White Papers on Best Business Practices
Un ce r t a in t y :
Th e N e w Ru le s for St r a t e gy
Mart ha Am ram
Nalin Kulat ilaka 1
March, 1999
prepared for t he Journal of Business St rat egy
Most grow t h opport unit ies share a com m on feat ure: uncert aint y. I n t oday’s
econom y, st rat egic invest m ent s m ust be m ade w it hout a pinpoint forecast of t he
fut ur e. At fir st t his seem s like a quest ion of bad input s – “ j ust go find t he dat a! ” But
it ’s not .
Managing in t he face of uncer t aint y is differ ent . I t r equir es t w o im por t ant
skills: t he abilit y t o ident ify valuable oppor t unit ies and t he abilit y t o adapt t o
m arket place changes. Managers oft en int uit e a connect ion bet w een st r at egic
invest m ent s and value, even w hen t here are no im m ediat e cashflows. How m any
t im es have you ignored a quant it at ive analysis, j ust ifying a proj ect on “ st rat egic
grounds” ? We need t ools and m et hodologies t hat m ake t his link visible. And,
m anagers m ust be able t o capit alize on good out com es of uncert aint y, t hey m ust be
adapt ive and flexible. I s t here a proj ect in your com pany t hat w ent exact ly as
planned? Or w ere t he best proj ect s one t hat adapt ed t o changing condit ions? We
need a capabilit y – t im ely inform at ion, decision m aking t ools and organizat ional
support – for guiding proj ect s t hrough uncert ain environm ent s.
Tradit ional valuat ion and st rat egic planning t ools don’t w ork very w ell in a
w orld of uncert aint y because t hey don’t fully capt ure t he opt ions or opport unit ies
1
m anagers have t o respond t o unfolding event s. We’ve writ t en a book about a new
approach, real opt ions t hat “sees” t hese opport unit ies and values t hem , creat ing an
int egrat ed st rat egy and valuat ion fram ew ork.
The real opt ions approach has it s origins in finance, st art ing w it h t he Nobel
Prize w inning w ork on valuing financial opt ion cont ract s. Early on, academ ics saw
how opt ion pricing m odels could be applied t o a variet y of non- financial or real
asset s. And t hey saw t hat t he real opt ions approach could be a bridge bet ween
finance and st rat egy – aft er all bot h disciplines at t em pt t o obt ain t he highest possible
ret urn on risky asset s.
The real opt ions approach has a host of im m ediat e applicat ions. We’d like t o
int roduce som e of t he key ideas by t hinking t hrough a hot t opic: t he value of
I nt er net com panies. Then w e’ll give you exam ples from com panies in t hree ot her
indust ries and close w it h t he new rules for st rat et gy under uncert aint y – insight s
w e’ve developed from w orking w it h com panies using t he real opt ions approach.
Va lu in g t h e N e w Gr ow t h Oppor t u n it ie s
I nt ernet com panies t ypify t he current valuat ion dilem m a, but t he sam e issues
are present in grow t h opport unit ies t hroughout high and low - t ech indust ries. Why
are w e having such a hard t im e valuing I nt ernet com panies? Because t he t radit ional
valuat ion t ools used by Wall St reet are from anot her era – t hey are based on
account ing syst em s for m anufact uring com panies in st able indust ries and are
focused on current and near- t erm cashflow . The valuat ion problem for m odern
grow t h opport unit ies, I nt ernet com panies included, is hugely different : How do you
value an im m at ure, fast grow ing com pany in a young indust ry w it h rapidly changing
1
Martha Amram is a consultant and President of Glaze Creek Partners in Palo Alto, CA. Nalin Kulatilaka
is Professor of Finance at Boston University. They are the authors of Real Options: Managing Corporate
Investment in an Uncertain World (HBS Press, 1999.) See www.real-options.com for more information.
2
boundaries and business m odels? Let ’s walk t hrough how t he real opt ions approach
can be used t o answ er t his quest ion.
The value of an I nt ernet com pany depends on how it w ill deal w it h four key
feat ures of t he I nt ernet environm ent : enorm ous uncert aint y; a com pet it ive
landscape paced by t echnology innovat ion; a need t o rapidly adapt t o changing
condit ions; and t he cost s of searching for a profit able business m odel. I n t he
I nt ernet w orld, t oday’s successful st rat egy does not guarant ee fut ure profit s; oft en
t he com pany m ust “ m orph” t o t he next t hing. None of t hese feat ur es fit t he
t radit ional cashflow- based approach.
We’ve developed a t wo- phased approach t o apply real opt ions t hinking t o
I nt ernet com pany valuat ion. The first phase st art s at t he back. What is t he m at ure
com pany business m odel and w hat is it s value? Wall St reet ’s t ools w ork fairly w ell
for m at ure com panies because t hey have a fixed and known st rat egy. But t oo oft en
Wall St r eet ’s analysis also st ops at t he back, as analyst s gloss over t he challenge of
t he j ourney t o t he end gam e - - neglect ing w hat it t akes t o get t here.
The second phase exam ines t he opt ions an I nt ernet com pany m ust acquire
and execut e t o get t o t he end gam e. We argue t hat m ost com pany invest m ent s in
t he volat ile I nt ernet w orld are opt ions – business invest m ent s t hat cr eat e t he
opport unit y t o m ake decisions in t he fut ure, aft er event s unfold. For exam ple, a w eb
sit e creat es an opt ion for furt her invest m ent , t hat of building and t est ing an ecom m erce connect ion t o cust om ers. A successful I nt ernet com panies recognizes
t hat reaching m at urit y requires it t o invest in a sequence of opt ions. The final set of
opt ions leads t o m at ure com pany st at us and cashflow . The next one back creat es
t he opport unit y t o invest in t he final set of opt ions, t he second one back creat es t he
opport unit y t o invest and so on. Bet w een now and m at urit y, t he com pany’s value is
dr iven by it ’s abilit y t o ident ify and execut e t he sequence of opt ions.
3
As our sidebar show s, t hese opt ions can be quant ified. I n fact , t here is
enorm ous rigor behind our approach, as st rat egic opt ions can be valued using t he
arsenal of t ools developed for financial opt ions. Using t he opt ions approach allow s
com pany valuat ions t o sensibly reflect t he fut ure, despit e t he lack of current or neart erm cashflow.
We t hink Wall St r eet and r et ail invest or s have been t r ying t o st r et ch
cashflow - based approaches t o valuat ion t oo far, neglect ing t o t hink t hrough w hat it
is required for an I nt ernet com pany t o reach m at urit y. I t ’s going t o t ake flexibilit y
and furt her invest m ent s. I t t akes a w illingness t o adapt and abilit y t o repeat edly
raise capit al. Not all com panies w ill survive, and t oday’s valuat ions should be
discount ed t o reflect t he t rue odds. Right now , m any invest ors are relying on
cashflow - based m odels t o benchm ark value ( w hich can’t work) , and valuat ions are
ranging widely. The bet t er- anchored opt ions- based approach narrows t he range of
r easonable valuat ions.
Valuing an I nt ernet com pany present s m any of t he sam e issues as valuing
corporat e growt h opport unit ies, part icularly in how st rat egy and valuat ion are
int ert w ined. The real opt ions approach helps t o ident ify t he m ost valuable st rat egies
for a w orld of uncert aint y.
Th e N e w St r a t e gie s in Act ion
Let ’s look at t hree applicat ions of t he real opt ions approach t o valuat ion and
st rat egy. These applicat ions span a w ide range and illust rat e how t he real opt ions
approach is int egrat es a variet y of issues int o a single st rat egic valuat ion fram ew ork.
Our fir st applicat ion is invest m ent s in infor m at ion t echnology ( I T) . For m ost
com panies, I T invest m ent is no longer a side issue but one cent ral corporat e st rat egy
4
in fast - m oving m arket s. For exam ple, suppose t he chief inform at ion officer m ust
decide bet w een a server t hat fit s t oday’s needs plus reasonable growt h or prem ium priced server t hat w ill accom m odat e ult ra- fast grow t h. I s t he great er expense
j ust ified when ult ra- fast growt h m ay or m ay not happen? The real opt ions approach
recognizes t hat t he prem ium - priced server creat es an opt ion for ult ra- fast grow t h,
and helps t he st rat egist link server feat ures t o t he value and likelihood of st rat egic
obj ect ives. The server should be purchased only if t he value of t he opt ion it creat es
exceeds t he price prem ium .
Our second applicat ion is oil explorat ion. Consider t he case of seism ic
explorat ion, in w hich sound w aves are used t o im prove t he est im at e of how m uch oil
is in t he ground. An explorat ion invest m ent w ill narrow t he range of uncert aint y
So t he key quest ion for t he pet r oleum engineer is w het her t he value of t he im pr oved
infor m at ion exceeds t he explor at ion cost . At som e point , t her e is no point in
spending t o reduce uncert aint y and t he reserve is eit her developed or abandoned.
The real opt ions approach int egrat es t he geological uncert aint y w it h oil price
uncer t aint y so t hat explor at ion decisions ar e in line w it h valuat ions in t he oil
m arket s.
The t hird applicat ion is int ellect ual propert y. For an increasing num ber of
com panies, an im port ant source of revenue com es from licensing and selling
int ellect ual propert y. The t erm s and condit ions on t hese licenses can be com plex,
including paym ent s for perform ance, royalt ies, lim it at ions on use and so on. For
exam ple, one com pany m ay offer t o reduce t he upfront fee required from $4 m illion
t o $2 m illion if t he royalt y rat e is increased from 1% t o 2% w it h a floor of 50 cent s
per unit . The real opt ions approach can be used t o quant ify t he value of t he t w o
pr oposals, including t he floor . Tr adit ional valuat ion t ools cannot cor r ect ly value
floors and caps, so only t he real opt ions approach can keep all t he alt ernat ives on an
“ apples t o apples” basis.
5
Th e N e w Ru le s
Many st rat egist s are facing t he kinds of issues w e’ve been discussing. I n a
fast - m oving world of uncert aint y, m anagers m ust be ready t o respond. Here is a
st ar t ing point , 10 r ules for finding t he opt ions in your st r at egic invest m ent s.
1/ Make no assum pt ions: What is your m arket ?
Technology and deregulat ion are rapidly blurring convent ional indust ry definit ions.
Ret hink your m arket boundaries and com pet it ors t hrough t oday’s cust om er- cent ric
lens. I nclude sources of uncert aint y and how indust ry players w ill respond.
2/ You already have som e answers: Use t he insight s from durable econom ics
A good part of t he New Econom y can be w ell underst ood using durable econom ic
pr inciples – concept s and fram eworks t hat are well known t o econom ist s, but oft en
skipped over in Econ101. Carl Shapiro and Hal Varian have w rit t en in a book t hat
deft ly m akes t his point . As t he aut hors st at e “ Technology changes. Econom ic law s
do not .” 2
3/ I dent ify your opt ions
Great er uncert aint y creat es t he need for great er flexibilit y. Where are t he opt ions
for fut ure flexibilit y in your current proj ect s? For exam ple, your plant expansion
com es w it h an opt ion t o w ait – you can st art it now or lat er. Your plant t hat is
current ly running has an opt ion t o shut down. ( Rem em ber – t he opt ion t o shut dow n
w ill have som e value even w hen it is not likely t o be used! )
Because t r adit ional
quant it at ive analyses ignore t hese opt ions, you can add t heir value t o a discount ed
cash flow r esult .
6
4/ Nurt ure your opt ions
Not hing is fr ee, including t he opt ions you j ust ident ified. What w ill it t ake t o keep
t hese alive as viable invest m ent oppor t unit ies? And som et im es, t he value of t he
opt ion is not w ort h t he it s cost . For exam ple, cont inuing an R&D proj ect creat es t he
opt ion t o t urn it int o a com m ercial product . You don’t know if you w ill, but you
m ight . I n som e cases, t he prom ise ( value of t he business opport unit y and likelihood
you’ll cont inue) m akes t he opt ion t o cont inue valuable, in ot her cases you are bet t er
off canceling t he proj ect . And w e’ve got som e bad new s: Tradit ional t ools, such as
discount ed cash flow , com plet ely m iss t he value of risky, long- t erm proj ect s such as
R&D. Ther e’s no easy fix, but because t he st andard approach always under values
R&D- t ype act ivit ies, your com pany m ay be under- invest ing in new product s.
5/ Get ready for flexibilit y
Can you really cancel a proj ect in your com pany? Can you m ake t his decision
obj ect ively? Can you m ake it in t im e t o lim it losses? Flexibilit y cut s bot h w ays – it
capt ures upside pot ent ial and saves you from sinkholes. But only if you are ready t o
act . Oft en w e hear corporat e st aff essent ially saying: “ I see t he opt ion, and t he
course of act ion, but m y boss is such a lunkhead; she’s paralyzed.” The ideas w e’ve
present ed w ill rem ain rat her academ ic if your organizat ion is not ready. As you
ident ify an opt ion, you can help t o r ealize it s value by ident ifying t he r ight
decisionm akers, giving t hem t he appropriat e incent ives and m aking sure t hey get
t he right inform at ion.
6/ I t ’s not your choice: t he pace of decisionm aking
2
Carl Shapiro and Hal Varian, Information Rules, HBS Press, 1998
7
How oft en does your com pany review it s st rat egic proj ect s? What prom pt s a
decision t o be m ade? To capt ure t he value of opport unit ies t o respond t o unfolding
event s, t he pace of decisionm aking and proj ect review m ust be in st ep w it h ext ernal
event s. I n t he food processing, it m ay be necessary t o review use of t he t em porary
shut dow n opt ion on a seasonal basis. I n t he m ovie indust ry, dist ribut ion and
advert ising st rat egies are review ed each w eek, based on t he w eekend’s box office
receipt s. Now t hat t he aut o indust ry is building significant elect ronic feat ures int o
our cars and m eet ing cust om ers over t he I nt ernet , w ill t heir pace of decisionm aking
also need t o change? Annual and quart erly st rat egic planning review s have t heir
place, but t hey cannot drive decisionm aking w it hout giving up subst ant ial value from
t he t im ing com ponent of m any corporat e opt ions.
7/ Creat e opt ions
On t he first pass of an invest m ent review , you can add significant value over
convent ional valuat ion approaches by ident ifying t he opt ions. On t he second pass,
you can get a sim ilar st ep up in value by creat ing opt ions. For exam ple, creat e t he
opt ion t o change course, re- focus or even abandon m idw ay t hrough a proj ect . One
New Econom y firm , Viant , has t aken t his concept a st ep furt her. They break dow n
t heir e- com m erce/ e- com pany im plem ent at ion proj ect s for client s int o 90- day
m odules. This reduces t he im plem ent at ion risk, but m ore im port ant ly, Viant is
creat ing valuable opt ions for t heir client s. The 90- day m odule creat es a focus on
learning from what has been done and on responding t o m arket and t echnology
event s - - and t he opt ion t o m ake new decisions. Viant w ins because it ’s easier t o
sell t he m ore valuable, flexible process. The cust om er w ins because t hey're get t ing
a m ore valuable proj ect , one t hat includes opt ions. And of course Viant needs t o
com m unicat e t hat opt ions are valuable, even w hen not used. ( I ncluding t he opt ion t o
drop Viant or t he proj ect ! )
8
8/ Too m any opt ions, t oo few resources: You can’t do it all
Opt ions change t he m eaning of focus. I dent ifying, nur t ur ing, and creat ing
opt ions t akes subst ant ial t im e and energy. Meanw hile your indust ry pace is picking
up, t echnology is becom ing m ore com plex and it ’s har d t o hir e t he key people in
your core business area. Regis McKenna said it 1985, and it ’s st ill t r ue t oday: “ As
t echnologies advance and becom e int ert w ined w it h one anot her, no single com pany
has t he full range of skills and expert ise t o bring product s t o m arket in a t im ely and
cost - effect ive w ay.” 3 Hence you need t o focus on your core capabilit ies, and all t he
associat ed opt ions, part nering for t he rest . Have you not iced t hat even Microsoft
doesn’t do it all?
9/ Cont ract ing t ransparency: Discipline is here
Everybody’s cont ract ing. Elect ric power com panies now m eet dem and by
generat ing power or cont ract ing for power. Telecom m inut es and bandwidt h is now
bought and sold on four different exchanges. Biot ech com panies rout inely develop
product s w it h t he int ended st rat egy of licensing m arket ing right s t o a large
pharm aceut ical com pany. Ot her biot echs, such as The Medicines Com pany, acquire
drugs in lat e- st age developm ent t hrough a license and t hen com plet e t he product .
( Act ually, t hey don’t even com plet e t he product t hem selves, t hey part ner – t hr ough
cont ract s – wit h ot her com panies.)
There are t w o crit ical point s of discipline in t hese cont ract s. First , physical
and cont ract ual asset s m ust line up. Elect ric pow er generat ion asset s, for exam ple,
are no m ore valuable t han t he cont ract s w rit t en on t hem . And cont ract s for pow er
can’t be at prices higher t han self- generat ion. Second, cont ract s and licenses w rit t en
by publicly t raded com panies are t ransparent . When Silicon Graphics t ook it s MI Ps
9
division public, one financial m arket analyst com m ent ed: “ MI Ps is going t o live and
die by it s licenses.” Wall St reet is w at ching t he pricing and t erm s of MI Ps licenses,
and capit alizing t he infor m at ion int o t heir st ock pr ice. As t he m ar ket s cont inue t heir
w ork t o pull t hese forces t oget her, it is not unreasonable t o expect a publicly t raded
com pany t o have cont ract s disciplined by ot her pricing of risk and ret urn in t he
m arket s and by t he alt ernat ives provided by it s ow n physical asset s.
10/ New Econom y or Dow: You’ve got t o ask t he right quest ions
New Econom y firm s w rest le w it h t he I nt ernet , t he e- com pany, digit al plum bing, and
int ellect ual pr oper t y. And t hese issues t hr eat en t he business m odels of m ost
sm okest ack indust ries as w ell. From Hallm ark t o Fed Ex t o General Mot ors,
t echnology is st art ing t o set off a t idal w ave of change.
To m ake sense out of t his
enorm ous and broadbased phenom ena, we need a new fram e of reference, a new
w ay of t hinking. And w e need t o collect new and different kinds of inform at ion.
We’ve got t o st art asking t he right quest ions: What are t he drivers of uncert aint y?
What ’s it s m agnit ude? Where are t he decision point s? What are opport unit ies t o
incr ease upside pot ent ial? What ar e t he oppor t unit ies t o lim it losses? At w hat cost ?
What w ill it t ake t o r em ain flexible? When is it w or t h it ? Can w e get our flexibilit y
and opt ions m ore cheaply t hrough cont ract s? And so on.
Wit h st andard approaches and t ools, it s going t o feel like you’re on a lifeboat
in a sea of chaos. Change your t hinking. See how t o creat e value out of
uncert aint y, and how t o rem ain a nim ble com pet it or – always afloat – as t he waves
of change roll t hrough.
________________________________
A Real Options Application:
3
The Regis Touch, page. 68
10
The Strategy and Valuation of a New Venture
To make the real options approach concrete, let’s walk through an example.
We’ll lay out the flow of calculations here and present the results. If you would like to
see more detail, download the spreadsheet at www.real-options.com/jbs.html
Portlandia Ale is two guys and a dream. The company needs $4 million to begin
product development and manufacturing and another $12 million in two years for its
market launch. The entrepreneurs are very optimistic about their business opportunity,
despite considerable uncertainty about the value of the market opportunity they’re
chasing.
[Figure 1 about here]
Portlandia is showing potential investors a traditional business plan. $500,000
would be spent each quarter for the first two years. Then $12 million would be spent in
the first quarter of the third year to launch the product line. The business plan assumes
the launch would be successful, leading to a sustainable business with a market value of
$22 million. (The value of the sustainable business is calculated as: M/S x Portlandia’s
sales, where M/S is the average market value to sales ratio for mature microbrewery
companies.)
Even under two optimistic assumptions –business conditions will support the
sales forecast in the plan; and the launch will be made – the value of Portlandia under the
traditional business plan is negative $230,000.
The business plan fails to include the valuable option held by the startup:
Portlandia need not undertake the market launch. The launch will only be made if
business conditions are strong enough to make the launch profitable. Portlandia’s
strategy is more complex and its valuation is higher than is recognized by a traditional
business plan.
The Black-Scholes equation is a well-known formula for pricing financial option
contracts and can also be used to value Portlandia’s launch option. The formula – for
which Myron Scholes and Robert Merton won the 1997 Nobel Economics Prize –
requires only five inputs to produce a single output, the current value of the option. (A
note of caution: not all real options can be valued so easily. Many corporate options are
more complex and require tailored mathematical formulae. (See the website for the
Black-Scholes calculations for this example and for more information on other methods.)
The current value of Portlandia’s option to launch is $4.96 million. It’s value
comes from the upside potential. If two years from now business conditions are terrific,
then there will be a very high payoff to the $12 million launch cost. If two years from
now business conditions are poor, the product will not be launched and the $12 million
will not be needed. Portlandia now has a contingent strategy, one that depends on
business conditions. Before the launch decision date, Portlandia’s total product
development cost will be $3.83 million in present value terms. The value of Portlandia
with the launch option is $1.13 million ($4.96 million – $3.83 million.)
11
Now let’s more realistically characterize Portlandia’s strategy by adding a second
option: the option to abandon. Suppose that at any time during the first two years
Portlandia could cease operations if business conditions soured to such a level that
Portlandia could not see making the launch. The calculations are now a bit more
complex, and require specialized mathematical tools known as numerical methods -tools widely used in engineering, science and on Wall Street.
The option to launch and the option to abandon are valued in an integrated
manner, resulting in a $1.74 million valuation for Portlandia. The traditional business
plan undervalues Portlandia because it fails to recognize that the company will be using a
contingent strategy, one that responds to unfolding conditions.
This brief example illustrates a numerical implementation of the real options
approach and demonstrates how traditional tools severely undervalue investments with
options. The magnitude of increase given here, from -$0.23 million in a traditional
business plan to $1.74 million for valuation that includes the key options, is fairly typical
of strategic growth opportunities.
12
Th e N e w Ru le s for St r a t e gy
Mart ha Am ram
Nalin Kulat ilaka 1
March, 1999
prepared for t he Journal of Business St rat egy
Most grow t h opport unit ies share a com m on feat ure: uncert aint y. I n t oday’s
econom y, st rat egic invest m ent s m ust be m ade w it hout a pinpoint forecast of t he
fut ur e. At fir st t his seem s like a quest ion of bad input s – “ j ust go find t he dat a! ” But
it ’s not .
Managing in t he face of uncer t aint y is differ ent . I t r equir es t w o im por t ant
skills: t he abilit y t o ident ify valuable oppor t unit ies and t he abilit y t o adapt t o
m arket place changes. Managers oft en int uit e a connect ion bet w een st r at egic
invest m ent s and value, even w hen t here are no im m ediat e cashflows. How m any
t im es have you ignored a quant it at ive analysis, j ust ifying a proj ect on “ st rat egic
grounds” ? We need t ools and m et hodologies t hat m ake t his link visible. And,
m anagers m ust be able t o capit alize on good out com es of uncert aint y, t hey m ust be
adapt ive and flexible. I s t here a proj ect in your com pany t hat w ent exact ly as
planned? Or w ere t he best proj ect s one t hat adapt ed t o changing condit ions? We
need a capabilit y – t im ely inform at ion, decision m aking t ools and organizat ional
support – for guiding proj ect s t hrough uncert ain environm ent s.
Tradit ional valuat ion and st rat egic planning t ools don’t w ork very w ell in a
w orld of uncert aint y because t hey don’t fully capt ure t he opt ions or opport unit ies
1
m anagers have t o respond t o unfolding event s. We’ve writ t en a book about a new
approach, real opt ions t hat “sees” t hese opport unit ies and values t hem , creat ing an
int egrat ed st rat egy and valuat ion fram ew ork.
The real opt ions approach has it s origins in finance, st art ing w it h t he Nobel
Prize w inning w ork on valuing financial opt ion cont ract s. Early on, academ ics saw
how opt ion pricing m odels could be applied t o a variet y of non- financial or real
asset s. And t hey saw t hat t he real opt ions approach could be a bridge bet ween
finance and st rat egy – aft er all bot h disciplines at t em pt t o obt ain t he highest possible
ret urn on risky asset s.
The real opt ions approach has a host of im m ediat e applicat ions. We’d like t o
int roduce som e of t he key ideas by t hinking t hrough a hot t opic: t he value of
I nt er net com panies. Then w e’ll give you exam ples from com panies in t hree ot her
indust ries and close w it h t he new rules for st rat et gy under uncert aint y – insight s
w e’ve developed from w orking w it h com panies using t he real opt ions approach.
Va lu in g t h e N e w Gr ow t h Oppor t u n it ie s
I nt ernet com panies t ypify t he current valuat ion dilem m a, but t he sam e issues
are present in grow t h opport unit ies t hroughout high and low - t ech indust ries. Why
are w e having such a hard t im e valuing I nt ernet com panies? Because t he t radit ional
valuat ion t ools used by Wall St reet are from anot her era – t hey are based on
account ing syst em s for m anufact uring com panies in st able indust ries and are
focused on current and near- t erm cashflow . The valuat ion problem for m odern
grow t h opport unit ies, I nt ernet com panies included, is hugely different : How do you
value an im m at ure, fast grow ing com pany in a young indust ry w it h rapidly changing
1
Martha Amram is a consultant and President of Glaze Creek Partners in Palo Alto, CA. Nalin Kulatilaka
is Professor of Finance at Boston University. They are the authors of Real Options: Managing Corporate
Investment in an Uncertain World (HBS Press, 1999.) See www.real-options.com for more information.
2
boundaries and business m odels? Let ’s walk t hrough how t he real opt ions approach
can be used t o answ er t his quest ion.
The value of an I nt ernet com pany depends on how it w ill deal w it h four key
feat ures of t he I nt ernet environm ent : enorm ous uncert aint y; a com pet it ive
landscape paced by t echnology innovat ion; a need t o rapidly adapt t o changing
condit ions; and t he cost s of searching for a profit able business m odel. I n t he
I nt ernet w orld, t oday’s successful st rat egy does not guarant ee fut ure profit s; oft en
t he com pany m ust “ m orph” t o t he next t hing. None of t hese feat ur es fit t he
t radit ional cashflow- based approach.
We’ve developed a t wo- phased approach t o apply real opt ions t hinking t o
I nt ernet com pany valuat ion. The first phase st art s at t he back. What is t he m at ure
com pany business m odel and w hat is it s value? Wall St reet ’s t ools w ork fairly w ell
for m at ure com panies because t hey have a fixed and known st rat egy. But t oo oft en
Wall St r eet ’s analysis also st ops at t he back, as analyst s gloss over t he challenge of
t he j ourney t o t he end gam e - - neglect ing w hat it t akes t o get t here.
The second phase exam ines t he opt ions an I nt ernet com pany m ust acquire
and execut e t o get t o t he end gam e. We argue t hat m ost com pany invest m ent s in
t he volat ile I nt ernet w orld are opt ions – business invest m ent s t hat cr eat e t he
opport unit y t o m ake decisions in t he fut ure, aft er event s unfold. For exam ple, a w eb
sit e creat es an opt ion for furt her invest m ent , t hat of building and t est ing an ecom m erce connect ion t o cust om ers. A successful I nt ernet com panies recognizes
t hat reaching m at urit y requires it t o invest in a sequence of opt ions. The final set of
opt ions leads t o m at ure com pany st at us and cashflow . The next one back creat es
t he opport unit y t o invest in t he final set of opt ions, t he second one back creat es t he
opport unit y t o invest and so on. Bet w een now and m at urit y, t he com pany’s value is
dr iven by it ’s abilit y t o ident ify and execut e t he sequence of opt ions.
3
As our sidebar show s, t hese opt ions can be quant ified. I n fact , t here is
enorm ous rigor behind our approach, as st rat egic opt ions can be valued using t he
arsenal of t ools developed for financial opt ions. Using t he opt ions approach allow s
com pany valuat ions t o sensibly reflect t he fut ure, despit e t he lack of current or neart erm cashflow.
We t hink Wall St r eet and r et ail invest or s have been t r ying t o st r et ch
cashflow - based approaches t o valuat ion t oo far, neglect ing t o t hink t hrough w hat it
is required for an I nt ernet com pany t o reach m at urit y. I t ’s going t o t ake flexibilit y
and furt her invest m ent s. I t t akes a w illingness t o adapt and abilit y t o repeat edly
raise capit al. Not all com panies w ill survive, and t oday’s valuat ions should be
discount ed t o reflect t he t rue odds. Right now , m any invest ors are relying on
cashflow - based m odels t o benchm ark value ( w hich can’t work) , and valuat ions are
ranging widely. The bet t er- anchored opt ions- based approach narrows t he range of
r easonable valuat ions.
Valuing an I nt ernet com pany present s m any of t he sam e issues as valuing
corporat e growt h opport unit ies, part icularly in how st rat egy and valuat ion are
int ert w ined. The real opt ions approach helps t o ident ify t he m ost valuable st rat egies
for a w orld of uncert aint y.
Th e N e w St r a t e gie s in Act ion
Let ’s look at t hree applicat ions of t he real opt ions approach t o valuat ion and
st rat egy. These applicat ions span a w ide range and illust rat e how t he real opt ions
approach is int egrat es a variet y of issues int o a single st rat egic valuat ion fram ew ork.
Our fir st applicat ion is invest m ent s in infor m at ion t echnology ( I T) . For m ost
com panies, I T invest m ent is no longer a side issue but one cent ral corporat e st rat egy
4
in fast - m oving m arket s. For exam ple, suppose t he chief inform at ion officer m ust
decide bet w een a server t hat fit s t oday’s needs plus reasonable growt h or prem ium priced server t hat w ill accom m odat e ult ra- fast grow t h. I s t he great er expense
j ust ified when ult ra- fast growt h m ay or m ay not happen? The real opt ions approach
recognizes t hat t he prem ium - priced server creat es an opt ion for ult ra- fast grow t h,
and helps t he st rat egist link server feat ures t o t he value and likelihood of st rat egic
obj ect ives. The server should be purchased only if t he value of t he opt ion it creat es
exceeds t he price prem ium .
Our second applicat ion is oil explorat ion. Consider t he case of seism ic
explorat ion, in w hich sound w aves are used t o im prove t he est im at e of how m uch oil
is in t he ground. An explorat ion invest m ent w ill narrow t he range of uncert aint y
So t he key quest ion for t he pet r oleum engineer is w het her t he value of t he im pr oved
infor m at ion exceeds t he explor at ion cost . At som e point , t her e is no point in
spending t o reduce uncert aint y and t he reserve is eit her developed or abandoned.
The real opt ions approach int egrat es t he geological uncert aint y w it h oil price
uncer t aint y so t hat explor at ion decisions ar e in line w it h valuat ions in t he oil
m arket s.
The t hird applicat ion is int ellect ual propert y. For an increasing num ber of
com panies, an im port ant source of revenue com es from licensing and selling
int ellect ual propert y. The t erm s and condit ions on t hese licenses can be com plex,
including paym ent s for perform ance, royalt ies, lim it at ions on use and so on. For
exam ple, one com pany m ay offer t o reduce t he upfront fee required from $4 m illion
t o $2 m illion if t he royalt y rat e is increased from 1% t o 2% w it h a floor of 50 cent s
per unit . The real opt ions approach can be used t o quant ify t he value of t he t w o
pr oposals, including t he floor . Tr adit ional valuat ion t ools cannot cor r ect ly value
floors and caps, so only t he real opt ions approach can keep all t he alt ernat ives on an
“ apples t o apples” basis.
5
Th e N e w Ru le s
Many st rat egist s are facing t he kinds of issues w e’ve been discussing. I n a
fast - m oving world of uncert aint y, m anagers m ust be ready t o respond. Here is a
st ar t ing point , 10 r ules for finding t he opt ions in your st r at egic invest m ent s.
1/ Make no assum pt ions: What is your m arket ?
Technology and deregulat ion are rapidly blurring convent ional indust ry definit ions.
Ret hink your m arket boundaries and com pet it ors t hrough t oday’s cust om er- cent ric
lens. I nclude sources of uncert aint y and how indust ry players w ill respond.
2/ You already have som e answers: Use t he insight s from durable econom ics
A good part of t he New Econom y can be w ell underst ood using durable econom ic
pr inciples – concept s and fram eworks t hat are well known t o econom ist s, but oft en
skipped over in Econ101. Carl Shapiro and Hal Varian have w rit t en in a book t hat
deft ly m akes t his point . As t he aut hors st at e “ Technology changes. Econom ic law s
do not .” 2
3/ I dent ify your opt ions
Great er uncert aint y creat es t he need for great er flexibilit y. Where are t he opt ions
for fut ure flexibilit y in your current proj ect s? For exam ple, your plant expansion
com es w it h an opt ion t o w ait – you can st art it now or lat er. Your plant t hat is
current ly running has an opt ion t o shut down. ( Rem em ber – t he opt ion t o shut dow n
w ill have som e value even w hen it is not likely t o be used! )
Because t r adit ional
quant it at ive analyses ignore t hese opt ions, you can add t heir value t o a discount ed
cash flow r esult .
6
4/ Nurt ure your opt ions
Not hing is fr ee, including t he opt ions you j ust ident ified. What w ill it t ake t o keep
t hese alive as viable invest m ent oppor t unit ies? And som et im es, t he value of t he
opt ion is not w ort h t he it s cost . For exam ple, cont inuing an R&D proj ect creat es t he
opt ion t o t urn it int o a com m ercial product . You don’t know if you w ill, but you
m ight . I n som e cases, t he prom ise ( value of t he business opport unit y and likelihood
you’ll cont inue) m akes t he opt ion t o cont inue valuable, in ot her cases you are bet t er
off canceling t he proj ect . And w e’ve got som e bad new s: Tradit ional t ools, such as
discount ed cash flow , com plet ely m iss t he value of risky, long- t erm proj ect s such as
R&D. Ther e’s no easy fix, but because t he st andard approach always under values
R&D- t ype act ivit ies, your com pany m ay be under- invest ing in new product s.
5/ Get ready for flexibilit y
Can you really cancel a proj ect in your com pany? Can you m ake t his decision
obj ect ively? Can you m ake it in t im e t o lim it losses? Flexibilit y cut s bot h w ays – it
capt ures upside pot ent ial and saves you from sinkholes. But only if you are ready t o
act . Oft en w e hear corporat e st aff essent ially saying: “ I see t he opt ion, and t he
course of act ion, but m y boss is such a lunkhead; she’s paralyzed.” The ideas w e’ve
present ed w ill rem ain rat her academ ic if your organizat ion is not ready. As you
ident ify an opt ion, you can help t o r ealize it s value by ident ifying t he r ight
decisionm akers, giving t hem t he appropriat e incent ives and m aking sure t hey get
t he right inform at ion.
6/ I t ’s not your choice: t he pace of decisionm aking
2
Carl Shapiro and Hal Varian, Information Rules, HBS Press, 1998
7
How oft en does your com pany review it s st rat egic proj ect s? What prom pt s a
decision t o be m ade? To capt ure t he value of opport unit ies t o respond t o unfolding
event s, t he pace of decisionm aking and proj ect review m ust be in st ep w it h ext ernal
event s. I n t he food processing, it m ay be necessary t o review use of t he t em porary
shut dow n opt ion on a seasonal basis. I n t he m ovie indust ry, dist ribut ion and
advert ising st rat egies are review ed each w eek, based on t he w eekend’s box office
receipt s. Now t hat t he aut o indust ry is building significant elect ronic feat ures int o
our cars and m eet ing cust om ers over t he I nt ernet , w ill t heir pace of decisionm aking
also need t o change? Annual and quart erly st rat egic planning review s have t heir
place, but t hey cannot drive decisionm aking w it hout giving up subst ant ial value from
t he t im ing com ponent of m any corporat e opt ions.
7/ Creat e opt ions
On t he first pass of an invest m ent review , you can add significant value over
convent ional valuat ion approaches by ident ifying t he opt ions. On t he second pass,
you can get a sim ilar st ep up in value by creat ing opt ions. For exam ple, creat e t he
opt ion t o change course, re- focus or even abandon m idw ay t hrough a proj ect . One
New Econom y firm , Viant , has t aken t his concept a st ep furt her. They break dow n
t heir e- com m erce/ e- com pany im plem ent at ion proj ect s for client s int o 90- day
m odules. This reduces t he im plem ent at ion risk, but m ore im port ant ly, Viant is
creat ing valuable opt ions for t heir client s. The 90- day m odule creat es a focus on
learning from what has been done and on responding t o m arket and t echnology
event s - - and t he opt ion t o m ake new decisions. Viant w ins because it ’s easier t o
sell t he m ore valuable, flexible process. The cust om er w ins because t hey're get t ing
a m ore valuable proj ect , one t hat includes opt ions. And of course Viant needs t o
com m unicat e t hat opt ions are valuable, even w hen not used. ( I ncluding t he opt ion t o
drop Viant or t he proj ect ! )
8
8/ Too m any opt ions, t oo few resources: You can’t do it all
Opt ions change t he m eaning of focus. I dent ifying, nur t ur ing, and creat ing
opt ions t akes subst ant ial t im e and energy. Meanw hile your indust ry pace is picking
up, t echnology is becom ing m ore com plex and it ’s har d t o hir e t he key people in
your core business area. Regis McKenna said it 1985, and it ’s st ill t r ue t oday: “ As
t echnologies advance and becom e int ert w ined w it h one anot her, no single com pany
has t he full range of skills and expert ise t o bring product s t o m arket in a t im ely and
cost - effect ive w ay.” 3 Hence you need t o focus on your core capabilit ies, and all t he
associat ed opt ions, part nering for t he rest . Have you not iced t hat even Microsoft
doesn’t do it all?
9/ Cont ract ing t ransparency: Discipline is here
Everybody’s cont ract ing. Elect ric power com panies now m eet dem and by
generat ing power or cont ract ing for power. Telecom m inut es and bandwidt h is now
bought and sold on four different exchanges. Biot ech com panies rout inely develop
product s w it h t he int ended st rat egy of licensing m arket ing right s t o a large
pharm aceut ical com pany. Ot her biot echs, such as The Medicines Com pany, acquire
drugs in lat e- st age developm ent t hrough a license and t hen com plet e t he product .
( Act ually, t hey don’t even com plet e t he product t hem selves, t hey part ner – t hr ough
cont ract s – wit h ot her com panies.)
There are t w o crit ical point s of discipline in t hese cont ract s. First , physical
and cont ract ual asset s m ust line up. Elect ric pow er generat ion asset s, for exam ple,
are no m ore valuable t han t he cont ract s w rit t en on t hem . And cont ract s for pow er
can’t be at prices higher t han self- generat ion. Second, cont ract s and licenses w rit t en
by publicly t raded com panies are t ransparent . When Silicon Graphics t ook it s MI Ps
9
division public, one financial m arket analyst com m ent ed: “ MI Ps is going t o live and
die by it s licenses.” Wall St reet is w at ching t he pricing and t erm s of MI Ps licenses,
and capit alizing t he infor m at ion int o t heir st ock pr ice. As t he m ar ket s cont inue t heir
w ork t o pull t hese forces t oget her, it is not unreasonable t o expect a publicly t raded
com pany t o have cont ract s disciplined by ot her pricing of risk and ret urn in t he
m arket s and by t he alt ernat ives provided by it s ow n physical asset s.
10/ New Econom y or Dow: You’ve got t o ask t he right quest ions
New Econom y firm s w rest le w it h t he I nt ernet , t he e- com pany, digit al plum bing, and
int ellect ual pr oper t y. And t hese issues t hr eat en t he business m odels of m ost
sm okest ack indust ries as w ell. From Hallm ark t o Fed Ex t o General Mot ors,
t echnology is st art ing t o set off a t idal w ave of change.
To m ake sense out of t his
enorm ous and broadbased phenom ena, we need a new fram e of reference, a new
w ay of t hinking. And w e need t o collect new and different kinds of inform at ion.
We’ve got t o st art asking t he right quest ions: What are t he drivers of uncert aint y?
What ’s it s m agnit ude? Where are t he decision point s? What are opport unit ies t o
incr ease upside pot ent ial? What ar e t he oppor t unit ies t o lim it losses? At w hat cost ?
What w ill it t ake t o r em ain flexible? When is it w or t h it ? Can w e get our flexibilit y
and opt ions m ore cheaply t hrough cont ract s? And so on.
Wit h st andard approaches and t ools, it s going t o feel like you’re on a lifeboat
in a sea of chaos. Change your t hinking. See how t o creat e value out of
uncert aint y, and how t o rem ain a nim ble com pet it or – always afloat – as t he waves
of change roll t hrough.
________________________________
A Real Options Application:
3
The Regis Touch, page. 68
10
The Strategy and Valuation of a New Venture
To make the real options approach concrete, let’s walk through an example.
We’ll lay out the flow of calculations here and present the results. If you would like to
see more detail, download the spreadsheet at www.real-options.com/jbs.html
Portlandia Ale is two guys and a dream. The company needs $4 million to begin
product development and manufacturing and another $12 million in two years for its
market launch. The entrepreneurs are very optimistic about their business opportunity,
despite considerable uncertainty about the value of the market opportunity they’re
chasing.
[Figure 1 about here]
Portlandia is showing potential investors a traditional business plan. $500,000
would be spent each quarter for the first two years. Then $12 million would be spent in
the first quarter of the third year to launch the product line. The business plan assumes
the launch would be successful, leading to a sustainable business with a market value of
$22 million. (The value of the sustainable business is calculated as: M/S x Portlandia’s
sales, where M/S is the average market value to sales ratio for mature microbrewery
companies.)
Even under two optimistic assumptions –business conditions will support the
sales forecast in the plan; and the launch will be made – the value of Portlandia under the
traditional business plan is negative $230,000.
The business plan fails to include the valuable option held by the startup:
Portlandia need not undertake the market launch. The launch will only be made if
business conditions are strong enough to make the launch profitable. Portlandia’s
strategy is more complex and its valuation is higher than is recognized by a traditional
business plan.
The Black-Scholes equation is a well-known formula for pricing financial option
contracts and can also be used to value Portlandia’s launch option. The formula – for
which Myron Scholes and Robert Merton won the 1997 Nobel Economics Prize –
requires only five inputs to produce a single output, the current value of the option. (A
note of caution: not all real options can be valued so easily. Many corporate options are
more complex and require tailored mathematical formulae. (See the website for the
Black-Scholes calculations for this example and for more information on other methods.)
The current value of Portlandia’s option to launch is $4.96 million. It’s value
comes from the upside potential. If two years from now business conditions are terrific,
then there will be a very high payoff to the $12 million launch cost. If two years from
now business conditions are poor, the product will not be launched and the $12 million
will not be needed. Portlandia now has a contingent strategy, one that depends on
business conditions. Before the launch decision date, Portlandia’s total product
development cost will be $3.83 million in present value terms. The value of Portlandia
with the launch option is $1.13 million ($4.96 million – $3.83 million.)
11
Now let’s more realistically characterize Portlandia’s strategy by adding a second
option: the option to abandon. Suppose that at any time during the first two years
Portlandia could cease operations if business conditions soured to such a level that
Portlandia could not see making the launch. The calculations are now a bit more
complex, and require specialized mathematical tools known as numerical methods -tools widely used in engineering, science and on Wall Street.
The option to launch and the option to abandon are valued in an integrated
manner, resulting in a $1.74 million valuation for Portlandia. The traditional business
plan undervalues Portlandia because it fails to recognize that the company will be using a
contingent strategy, one that responds to unfolding conditions.
This brief example illustrates a numerical implementation of the real options
approach and demonstrates how traditional tools severely undervalue investments with
options. The magnitude of increase given here, from -$0.23 million in a traditional
business plan to $1.74 million for valuation that includes the key options, is fairly typical
of strategic growth opportunities.
12