- Information
- AI Chat
Coy Exploiting Uncertainty The 'Real Options' Revolution in Decision-making Business Week 19990607
Corporate Financial Decision Making (FNCE20005)
University of Melbourne
Recommended for you
Preview text
Finance
CORPORATE PLANNING
EXPLOITING
UNOERTAINH
The "real-options"
revolution in
decision-making
T
his June, Enron Corp. will open three gas-fired power plants in northern Mississippi an(i western Tennessee that are inefficient—rleliberately so. They will generate electricity at an incremental cost 50% to 70% high- er than the industi-y's best. Most of the time, the production costs of these spanking new plants will be simply too high for them to compete. Eni'on liasn't gone crazy. By build- ing less efficient plants, it saved a bun- dle on constniction. It can let the plants sit idle, then fire them up when prices rise. Last June 25, the price of a megawatt-hour of electricity in parts of the Midwest soared—briefly^—from $4 0 to an unprecedented $7,000. With such volatility, Enron executives figure they can make money from their so-called peaking plants even if they operate only a week or so per year. What led Em'on executives to this counterintuitive notion? A revolution- ary concept in coi-pd'ate finance called "real options theoiy." In a nutshell, it says that when the ftiture is highly un- certain, it pays to have a broad range of options open. Eni'on's new plants ai-e, in effect, options: They give it the op- portunity but not the obligation to pro- duce electricity. Making money off liigh- cost power is no easy trick. But by using real-options theoi-y, Em-on's finan- cial wizai-ds figure that they can mine pi-ofits by calculating just the right time to lTin the plants, considei-ing pi'evailing power prices and the costs of starting up and shutting down.
Real-options analysis rewards fiexi- biiity—and that's what makes it better than today's standard decision-making tool, "net present value." NPV calculates the value of a project by predicting its payouts, adjusting them for risk, and subtracting the investment outlay. But by boiling down all the possibilities for the future into a single scenario, NPV doesn't account for the ability of execu- tives to react to new circumstances—for instance, spend a little up front, see how things develop, then either cancel or go full speed ahead. "AGILITY." The New Economy, which is marked by rapid change and lots of un- certainty, cries out for a tool like real options. These days, says Hewlett- Packard Co. CEO Lewis E. Platt, "any- one who tells you they have a 5- or 10- year plan is probably crazy. This is the age of scenario planning. You need not only speed but agility." Real-options analysis persuades companies to cj'eate lots of possibilities for themselves—for instance, by doing spade work on sev- eral projects at once. As events unfold, many options won't be worth pui"suing. But a few could be blockbusters. With an options approach, "uncertainty has the potential to be your Mend, not your enemy," says Paul E. Cîreenberg, a con- sultant at Analysis Group/Economics in Cambridge, Mass.
Although conceived more than 2 0 years ago, real-options analysis is just now coming Into wide use. Rapid change has exposed the weaknesses of less fiex- ible valuation tools. Experts have de- veloped rules of thumb that simplify the foiTnidable math behind options val- uation, while making real options ap- plicable in a bi'oader range of situations. And consulting firms have latched on to the techni(]ue as the Next Big Thing to sell to clients. "Real-options valua- tion has the potential to be a major
When the future is highly unpredictable, this theory says it
1 18 BiJSmESS WEEK / JUNE 7. 199 9
pays to have lots of options open
THE NEW MATH IN ACTION
Real-options analysis simply says that companies benefit by keeping their options open. Let's say a company is deciding whether to fund a large internet project that could either make or lose lots of mon- ey — most likely lose it A traditional calcu- lation of net present value, which disco'unts projected costs and revenues into today's dollars, examines the project as a whole and concludes it's a no-go. But a real- options analysis breaks it into stages and concludes it makes sense txyfund at least the first stage. Here's how it works:
EVALUATE EACH STAGE OF THE PROJECT SEPARATELY.
Say the first stage, setting up a —P IC j Web site, has a net present value of negative $50 million. The second stage, an E-commerce venture to be launched in one year, is tough to value. But let's say the best guess of its net present value is negative $300 million.
UNDERSTAND YOUR OPTIONS Setting up the Web site gives you the opportunity—but not the obligation—later to launch the E-commerce venture. In a year, you will know better whether that E-commerce opportunity is worth pursuing. If it's not, all you've lost is the investment in the Web site. However, the second stage could be immensely valuable.
REEVALUATE THE PROJECT USING AN OPTIONS MIND-SET
In the stock market, formulas such as Black-Scholes calculate how much you should pay for an option to buy, say, IBM at $260 a share by June 30 if its current price is $230. Think of the first stage of your Internet project as buying such an option—risky and out*of-the-money, but cheap.
GO FIGURE Taking into account the limited downside of building a Web site and the huge—albeit iffy—oppor- tunities it creates, real-options analysis could give the overall project a present value of, say, $70 million. So i:he no-go changes to a go.
BUSINESS WEEK /JUNE 7. 1999 11 9
"•"reasons
why you
should take our
SAFf
bourse.
**
Personal attention Small classes (8-12 students) ffk mean plenty of personal attention. ^*^ Would you rather work one-on- one? No one tutors more students for the SAT thon we do.
Better research I We spend millions of dollars each yeor researching tests and revising our techniques and materials.
Better scores
####### O
Prinietan Review SAT course students improve an average of 140points. 25%of ourstudent 5 improve 190 paints ar more.
Better colleges i More than 9 out of 10 Princeton Review students get into one of their top-chaice colleges.
Guaranteed results If yau don't improve your scores atleost 100 points, we'll work with you until you do.
THE
PRINCETON
REVIEW
Call18002-REVIEW or visit us at .reviov
Finance
them at that price isn't worth much. But if volatility is high, there's a good chance they will go above $260. That makes the option to buy them at $26 0 highly valuable. True, volatile shares can also plummet. But that doesn't mat- ter because the outcome is the same at any pi-ice below $260—the option is sim- ply allowed to expii-e. The Black-Scholes formula trans- formed financial-options trading in the Chicago pits and helped to create a global derivatives business with con- tracts whose face value today is in the trillions of dollars. Some experts think that real options will become even more important because they deal with real investments. Says Gordon A. Sick, a fi- nance professor at the University of Calgary: "I would expect fimis to ex- pend much gi'eatei" resources analyzing their real options than they do their financial options."
The term "real options" was coined in 197 7 by Stewart C. Myers of Massa- chusetts Institute of Technology. Its eai"- liest applications were In oil, ga. copper, and gold. and companies in those commodity businesses remain some of the biggest users. Chevron Corp. used real options in fonning its (unsuccessful) 199 7 bid for Elk Hills Naval Petroleum Reserve, a federal property in Califoniia. Anadai-ko Petro- leum Corp. of Houston says real-options analysis gave it the confidence to outbid others for a tract in the Gulf of Mexico called Tanzanite that has proved rich in oil and gas. Anadai'ko paid more be- cause Tanzanite's range of possible re- seives was so broad. Says Michael D. Cochran, vice-president foi worldwide exploration: "Most people looked at it and just saw the minimum case." BETTER ANSWERS. What's hot now is
the extension of real options beyond commodities—into biotechnology, phar- maceuticals, software, computer chips, and similar fields. This requires some innovation. The underlying asset of the option is no longer a traded product such as oil, whose going price can be plugged easily into a fonnula. Now, the asset that you get with the call option is something that's not traded—for exam- ple, a factory that hasn't even been con- structed yet. Its present value must be
estimated from projections of its futui-e cash flows. That's not a simple calculation, to be sure, but it gives better answers than the methods that most companies use today to make major investment deci- sions. Strictly speaking, net present val- ue theoi-y says that companies should ftmd eveiy project whose expected re- tiuTi exceeds the corporate cost of capi- tal. But Ti-easury Secretary-designate Lawrence H. Siunmers, in his past life as a Hai-vard Univei-sity economist, not- ed that companies set hui*dle rates for proposals that are far higher than their cost of capital. That's a vote of no confi- dence in NPV. "FAIL FAST." Real-options analysis helps decide when to kill projects that aren't working—following the Silicon Valley tradition of "fail fast." Equally im- portant, it helps de- cide when to keep projects alive. Ac- iiirding to McKin- t'y & Co., a strict Ni'V analysis would have had Apple I 'omputer Inc. quit ' lie personai-com- mter business in ilil)5-96 because it wasn't earning its cost of capital. But real-options analysis says that a period of losses can be a worthwhile price to pay for keeping alive an entei-prise that might eajTi big bucks in the futui-e. In- deed, today Apple is making money, and its market share is on the rise.
One reason Silicon Valley is embrac- ing i-eal options is that the method abets collaboration between companies. Tech- nology has become so complex that no company can supply evei-jthing it needs internally. A company creating an elec- tronic product may need to acquii-e up to 15 intellectual-property licenses. That can be enormously time-consuming, notes Adiiana G. Chiocchi, division coun- sel for worldwide sei-vices at Cadence Design Systems Inc. in San Jose, Calif. "If one deal takes months and you have 15 deals to do—hello? You're not going to be getting a lot of products out." So Chiocchi's team has designed an options-based method for valuing li- censes. It gave its model away to cus- tomers Intel Corp. and Toshiba Corp. for use in their negotiations, hoping for it to catch on as a standaixl. Says Chioc- chi: "The feedback was fantastic." To be sure, real-options analysis has
iemá al Ifie Colleae ímame bmimimi Smä 122 BUSINESS WEEK / JUNE 7, 199 9
Finance
its detractors. It's too complex to be worthwhile for minor decisions. And it's not useful for projects that require a full commitment right away, since the value of an option lies in the ability to spend a little now and decide later whether to forge ahead. That said, more and more companies are embracing real options. The Ten- nessee Valley Authority used them in a 199 4 decision to contract out for 2,00 0 megawatts of power instead of build- ing its own plants. In some cases, the TVA paid for options to buy power but never exercised them. That seems like a waste. On the other hand, power-pur- chase options are a more efficient buffer against unexpected demand than, say, building a nuclear power plant that might not be needed, says Larry Taylor, vice-president for bulk power trading. "It has been phenomenally successful at saving money and keeping the rates down," he says. Airbus Industrie uses the theory to calculate the value of the options that it gives to airlines to change or cancel or-
ders at the last nunute. Today, airlines don't know how much such options are worth compared with, say, a lower price per plane. So they can't weigh the trade-offs or easily compare deals of- fered by Airbus and arcbrival Boeing Co. Working with Alexis Triantis, a business professor at the University of Mai-yland, the Airbus director for North American airline marketing, John E. Stonier, has been quantifying the value of change and cancellation options. Says Stonier: "Doing this analysis has given us quite a lot of intuition that we didn't have." TWEAKING. Real-options theoiy has even found believers at Stern Stewart & Co., the consulting firm that has a trade- mai'k on a valuation method called "eco- nomic value added." EVA is a version of net present value analysis that uses a more accurate cost of capital to judge investment opportunities. But like stan- dard NFV, EVA undervalues a company such as Amazon Inc. that's losing money now because it's spending tons of money creating options for the futm-e.
Therefore, Stem Stewait is tweaking its EVA measm*es in order to incorporate forward-looking measures such as op- tions. Stem Stewaii Vice-President John L. McCoiTTiack says that the consultan- cy's generic EVA rankings, which have been published by Foiiune magazine, are "relatively simplistic" because they ignore the value of companies' options. A new generation of business ana- lysts is starting to be schooled in op- tions thinking. "In 5 or 10 yeai-s, every MBA coming out of a credible business school will know real options," says Lar- ry G. Chorn, a visiting professor of fi- nance at Thunderbird, the American Graduate School of Interaational Man- agement in Glendale, Ariz. Already, the major consulting firms are recruiting students versed in the field. Competing in the New Economy with infiexible management tools is like play- ing basketball in ski boots. Real options analysis lets you kick off those clunkers and sprint down the fioor. By Peter Coy in New York
OPTIONS. OPTIONS. EVERYWHERE
R
eal-options expert Robert S. Pindyck of Massachu- setts Institute of Technolo- gy tells people he has a terrible disease: "I see options every- where." Companies have all kinds of options: to raise produc- tion, to buy rivals, to move into related fields. Studying a compa- ny's portfolio of options provides insight into its growth prospects and thus its market value. That's why many on Wall Street are trying to contract Pindyck's options-spotting disease. "It's an important way of thinking about businesses and theii" potential," says Michael J. Mauboussin, a strate- gist at Credit Suisse Pii-st Boston (CSFB). "The thought process itself is very valuable."
ZEROING IN. Real-Options analysis is a big step beyond static valuation mea- suj'es such as price-earnings and price-to-book ratios. Comparing two companies on the basis of their p-e ra- tios is valid only if they have the same expected earnings growth. They harilly ever do. Real-options analysis zeroes in on what really mattei-s; the earnings growth itself. It values com- panies by studying the opportunities
they have for growth and wh. they can cash in on them. Manage- ment's skill becomes a niajor focus. Take America Online Inc., whose p-e is stratospheric, AOL stock would be only about 4% of wbat it is today if the mai'ket expected it to maintain profits at tbe cun-ent level forever. Real-options analysis gets a giip on whether the other 96% of AOL'S mai'- ket value is justified, says Martha Anu-am of Glaze Creek Pai-tners, a consultancy in Palo Alto, Calif. {She hasn't tried to do the calculations.) CSFB cable-TV analyst Laura Martin
recently used real-options analy- sis to conclude that cable stocks are under'alued. Real-options analysis can also conclude that companies ai'e ovei-valued. For instance, Amram argues that mi- croprocessor-design outfits Ad- vanced RISC Machines Ltd. and Mii'H Technologies Inc. are over- priced because they don't have good growth options. For one tiling, she says, it's hard to branch out from mia'oprocessors to designing other kinds of chips. "Don't look to options thinlong to explain the market cap of these companies," says Amram, co-author with Nalin Kulatilaka of Boston University of a new book, Real Options: Managi^ig Strategic In- vestnierit in an Ujicertain World.
Coming up with a tai'get price for a company by evaluating its real options is harder than lining up companies by theh- p-e's or five-year sales gi-owth. It means understanding the compa- nies, their industries, and managers' ability to take advantage of the op- tions open to them. Then again, who said stock picking was supposed to be easy? By Peter Coy in New York
12 4 BUSINESS WEEK / JUNE 7, 199 9
Coy Exploiting Uncertainty The 'Real Options' Revolution in Decision-making Business Week 19990607
Course: Corporate Financial Decision Making (FNCE20005)
University: University of Melbourne
