Hi all,Has anyone ever done any work with the "real options" approach to either investing or strategic decision making in business?Don't know what I'm talking about?www.real-options.comwww.realoptions.orgDamodaran is one of the academics involved in "real options" decision making. And I know that he's had some visibility on this board.Anyway, I've purchased some software and a huge, thick book on real options methodology with the hopes of becoming more educated on it.My hope is that someone on this board has some experience with real options and can provide some good insight.Thanks,Brad
I use real options all the time. My favorite book on the topic is Dixit & Pindyick's "Investment Under Uncertainty". However, if your not in operational control of an asset real option analysis can break down because you have to assume to operators of that asset will act in your bst interest. The result is that I don't feel that it makes for a good tool for a retail investor. Real options are a great way to capture some of the value associated with assets not captured otherwise, To more effectivly look at risk (vs. just upping the discount rate) and value it more appropriately. I know them well because the energy industry is one that has LOADS of real options. In fact, most books use examples from the energy industry. Many things can be broken down into options once you look at them. The question I would ask is, what are you trying to DO that requires real options?
I know you're going to laugh at this, but in the companies I've worked at so far (all large multinationals), the more "sophisticated" one used, (drum roll please), Internal Rate of Return (IRR) (okay, you can stop laughing now). To solve the time-value issue in IRR, all projects are assigned a common time frame for comparison, or the IRR is recomputed to equalize the time frame issue.The rest used (okay, now there should be no surprises this time) payback period (grumbling in the crowd ensues).Keep in mind that these are all chemical/manufacturing based companies. Still, no ROIC, no ERR, no NPV, nothing of the sort.Get this...the cost hurdle for the payback period guys is usually 1-3 years. What's wrong with that? Think about it...at a payback period of "1" years means that the project will pay itself off in the first year...so I can expense it and it will not affect the budget at all (unless I do it in December). And the 2-3 year stuff is well on the way to being paid off before it matters.The internal accounting/finance people and I would have a good laugh over it all, exchange looks of frustration, and then do it just the way that the company officers wanted it.In fact, not a single company I worked at has ever used anything other than straightline depreciation on projects except for tax purposes (where obviously they're using the MACR's system).And you don't even want to know what their criteria for capital vs. expensed projects are. I can't divulge anything of course without creating a huge IRS problem. Suffice to say that the most egregious abuses of capital budgets are major maintenance items. Instead of taking the budget hit as they should, or at the very least setting up an accrual account, they hide them in the capital expenditures. Everything else that is truly necessary gets expensed, and then capitalized anyways once it is successful!An extreme example that I can think of is a company that is European-owned. The Europeans do not recognize good will, and the company spent a small fortune (literally a prince's fortune) on buying up a company for an exhorbitant amount of money. Then they went through and did an "asset revaluation" and basically arbitrarily changed the value of assets on the books until they didn't have to charge off any good will. The end result is that the plant was reported as operating in the red most of the time simply because the phony depreciation expenses were over half of the plant's expenses.Anyways...I'm more interested in options for a different reason. It allows you to more correctly calculate the value of mergers & acquisitions, and other major structural changes to a company (such as selling off a product line). Dr. D's techniques work well for this. I believe it would also work well internally for a company making those same kinds of decisions. As far as capital spending goes however, I believe they are better served with just a set of strategic guidelines and a unified project valuation method such as NPV or ERR (or modified IRR if you really must).
Hi Brad,This is not the wisdom you're looking for, but I came across the term in a book called Expectations Investing and was intrigued. The idea that you can place a value on a possible future move of a company and therefore make your IV calculation more "accurate" is a neat one.Two things strike me, and I'm sure the book(s) address(es) them:1) As far as I can tell, it requires you to place some sort of probablility on the "exercise" of the real option. To me this just increases the number of best-guess variables you're including in your already approximate IV calculations.2) It also seems that, like equity derivative options, once the opportunity expires, the value goes away. If you purchase a stock with the option priced in and the option expires, that component of your value goes away, which is obvious, but it seems that the margin of safety that I'd add to overcome this could bring you back to your pricing before the real option.However, these concerns are from my perspective as a beginning investor. I think it's a very neat idea and could at least give you a better understanding of how the company operates.Jimmy
Thanks for the feedback from everyone.I'm learning about the Real Options methodology in hopes of using it to further my career. I can use it not only in revenue management analyses, but also as an aid in making important asset-related decisions (whether or not to sell that $10,000,000 parcel of land).Thanks again,Brad
PaulEngr, I disagree with you. I firmly believe that all companies should at least consider real options when doing capital spending. Some smaller projects you could skip this on, but most projects need to have the growth options they could unlock examined before accepting or rejecting them. Some projects create possible future oportunities that can be so huge that once valued with a real options framework can be explained in a quantative manner as being better project vs. projects with a higher NPV. To ignore these real options is to ignore value creation oportunities which will put a firm at a disadvantage over time. Firms do need set valuation guidelines and staff that is able to do an accurate analysis. I've seen the economics for a LNG facility that was built such that the capacity of the facility could be made 3 times larger than it currently is. Everything was designed and built so that it could be expanded at a later date without tearing the plant apart and shutting it down. This added a 3% percent onto the building costs and lowered the costs of doing an expansion by 50%. This was a great slam dunk, home run real option, the value of the option is greatly in excess of the cost to construct it. The energy business is one that has a lot of real options in it, and also have been first to use this framework of analysis.
FYI,Here is a options paper by damodaranhttp://pages.stern.nyu.edu/~adamodar/pdfiles/papers/realopt.pdf
Paul : in the companies I've worked at so far (all large multinationals), the more "sophisticated" one used, (drum roll please), Internal Rate of Return (IRR)Thanks for the reality check. That, unfortunately, is as sophisticated as it gets in large MNCs. If the project doesn't pay back in 3 years max. - it must be too difficult or too complicated - so go figure out a way to make it pay back faster! Though I must say I'm surprised to hear it's true even in the relatively more capital intensive industries you're referring to.not a single company I worked at has ever used anything other than straightline depreciation on projects Too true. Why make life difficult when you can K.I.S.S.?
I disagree with you. I firmly believe that all companies should at least consider real options when doing capital spending. Some smaller projects you could skip this on, but most projects need to have the growth options they could unlock examined before accepting or rejecting them.I'm not disagreeing. See, here's the rub that I have run into countless times:Companies usually group their capital projects into certain categories such as safety, environmental, legal, strategic, opportunities, and one that has a lot of names but maintenance capital is one name I've heard.Safety & Environmental are pretty much no-brainers. Everything in these is usually considered "must do" type stuff."Maintenance capital" or a couple other words that escapes me at the moment are projects that if you don't do them, you risk losing major pieces of your business. For instance, the transformer for the substation of a plant is leaking fluid and if it isn't replaced soon, it is going to fail. If it fails, the plant loses power and you're down for weeks until it you can get it rebuilt. It kind of falls in the same category as safety or environmental/legal projects.Strategic projects would be things like adding an component to be able to go after a new market or significantly increasing capacity. Usually, the capital is in support of a project initiated by marketting and/or upper management. So it gets "special" treatment. In other words, it gets done no matter what the payout is.Opportunities are all the little things that are cost reductions or plant improvments. Usually, they have an IRR, NPV, or payback period hurdle.The trouble is that the strategic projects slip through all of this without much of any scrutiny. Options pricing is appropriate when considering corporate strategy. And once you do that, you may as well push it all the way down the food chain, even if it simply amounts to a Black-Scholes model.All I was saying is that it's simply not being done anywhere I've worked, although it would be a significant tool. And the places I've worked have many commonalities with the energy sector (massive barriers to entry, limited deposits, enormous volumes, commodity-like products).What I have seen is that because of the schism between potential strategic opportunities and low-hanging but non-essential opportunities, several companies have had a rough time. They get so focussed on continuous incremental improvements that when a paradigm shift has the potential to occur, they completely miss it. The only time they get on the band wagon is once the competitors have already blazed a trail.
I've never NOT used real options when evaluating capital projects at the companies I've worked at. Upstream oil devolpment, refineries, powerplants, pipelines, IT spending, and LNG projects have all been things I have examined within a real options framework in my career. They have been standard tools taught to MBA's for the past 3-4 years. Projects with low risk and 1 year paybacks are no brainers, doing the slam dunk projects is easy. The tricky part is looking at the "grey" projects that are not slam dunks and if you don't use your best tools your missing value creating investment oportunities.
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