The concept of Real Options explained

A real option is the right, but not the obligation, to undertake a business decision. It is “real” because they relate to tangible assets or real-world capital projects.

A real option is characterised by:

• Step-wise decisions over time
• The decision alternatives are mutually exclusive
• The decisions can be optimised in light of new information that will be gained in the future.

By adopting a real options approach, you will be able to showcase how value can be created by preparing and reacting to both negative and positive outcomes of an uncertain future event.

Scaling options

Enables you to expand/reduce output (for instance within manufacturing) if the underlying uncertainties (for instance market response) turn out more/less favourable than expected.

Learning options

Enables you to delay investments until more information is acquired and learning has taken place. For instance connected to the outcome of a research project, or an early market entry.

Abandonment options

Enables you to temporarily suspend or abandon a project in order to limit losses if the underlying uncertainties turn out less favourable than expected. For instance, the abandonment of a new product line that proves less successful than expected.

Strategic options

Enables you to take advantage of possible successes in one project to increase the value of other projects. For instance, success in adopting new technology in one project allows the implementation of the new technology across relevant projects or may open up business opportunities that would otherwise be inaccessible.

Value creation

Based on the above, a Real Option can be defined as:

Investing in flexibility to make a decision some time into the future based on revealed information in order to avoid downsides and / or exploit upsides.

The value of options depends on the ability to identify how to use this flexibility and the new information gained
to optimise the sequence of decisions, following uncertain outcomes, throughout the project lifecycle. Generally, the larger the uncertainty, the higher the value potential of the real option.

Identifying real options

Identifying real options starts with focusing on the key project uncertainties, and how and when information about each underlying uncertainty can be revealed and how the project can take advantage of the updated information.

Then you have to outline the main decisions:

• For each decision, take two different decision alternatives and vary the key project uncertainties one at a time for each decision alternative.
• For uncertainties where one alternative is better for only parts of the outcome space, a real option potentially exists. The reason is that this proves that the optimal decision alternative may change if information about underlying uncertainty could be revealed.

The benefits

The benefits of using a real options approach can be summarised as follows:

Companies can select a roller coaster approach, where a strategy is selected, which implies a certain set of decisions the business goes along and things happen that impacts the results without the flexibility (or the option) to adapt along the way.

Or

Companies can select a value of information strategy, where a strategy is selected, which implies a certain set of decisions key uncertainties are identified and a conscious decision is made to maintain flexibility to the extent possible the business goes along and things happen and management has the flexibility to adapt along the way.

Decision tree structure

Classic structure

• One decision
• Two alternatives
• Two outcomes for each alternative
• Value at the decision point is the probability weighted value of the outcomes

Real option structure

• Adding the investment in flexibility – the real option
• Decide whether or not to invest in the real option
• If investing – there will be a new decision point when information has been revealed
• If the information is positive, select to exercise the option
• If the information is negative, decide not to exercise option

The delta value between the two branches – investing and not investing in the option is the Value of information.