What Exactly Are Real Options?

Unsurprising confession: when I was a scrappy young bachelor, I’d hit the clubs with friends. In a nightclub, anything can happen. I’ve started relationships, albeit not very healthy ones. Lots of Schwarzenegger bodies without Schwarzenegger minds emit intimidating body language. Even the roof can collapse (even though it’s unlikely).

By combining vodka and Red Bull, these muscleheads got the best of both worlds. Lots of energy, complete loss of inhibition, and a sense of being invincible came with this highly exotic cocktail. That combination, while it might have been great in a night club, in reality was a pretty dreadful combination elsewhere.

See, just because it may have been a good idea at the time, it doesn’t mean that the next day would have been so pleasant. The hangovers were terrible the following day.

They craved the loss of inhibition. I suspect some of these guys regretted doing things the next day. Saying things. Because they had alcohol, they had an excuse, in case somebody would hold them accountable, including themselves.

I like being in tune with my id as much as the next guy. I just don’t want to feel the need to explain myself to my conscience. The next day. Vodka and Red Bull was the easy way out. No need to think.

Effective planning requires that same level of conscientiousness. Time is precious. If you haven’t thought through what you’re trying to achieve, you are almost guaranteed to be wasting time. At least some.

Making sure that you’re moving towards your objectives, particularly in an uncertain environment, gives you much greater certainty.

Let’s say you want to make a decision among a couple of strategic alternatives. Each one has certain pros and cons. Each has consequences. Each constrains what you can do later. You’re also not sure how your competitors will react to each alternative. As a result, it’s not immediately clear which one would actually be the best choice. Each one has risk. Not choosing an option is also a risky option.
Enter real options analysis.

Real options help analyze the “big issues” for a company and its existence. They have to do with big milestones. In a corporate setting, having strategic clarity means that the whole company will find it much easier to execute. Everyone is “on the same page”. A strategic decision touches everyone. All stakeholders are affected.

This is analogous to the big milestones in a person’s life: birth, coming of age, marriage, death. All major religions and primitive cultures celebrate these milestones for people. They are important to everyone who knows that person. The community acts together.

Given that a corporation is a legal person created to maximize wealth and profits, real options help decide whether to take a specific path and when to do it.

According to Sick and Gamba:

Properly managed options create value and reduce risk for the organizations that own them. They arise because of the interplay of 4 things:
1. Real assets: financial options are generally redundant and hence do not create of destroy shareholder value. Real options cannot be replicated by stakeholders and generally create
value.
2. Risk: volatility and risk-return relationships.
3. Leverage: variable costs and benefits work against either fixed costs and benefits or imperfectly correlated costs and benefits.
4. Flexibility: to manage the risk and leverage by accepting upside risk potential and reducing downside risk.

As a decision-making tool, real options help you “cut to the chase” at any given moment. They estimate a financial value on each strategic choice, without forcing you to spend anything. Based on a few things you know or you can estimate, you can easily calculate an implied financial value for each choice. As a result, if you have a limited amount of resources, you create a metric that makes the choices comparable. You can compare $ to $.

You can also compare that value to the cost of choosing (buying) that option. Because both are denominated in financial terms, it’s easy to compare what you expect to get from making a particular decision, to the cost of choosing it.

Net Profit (Real Option) = E(Value) – E(Price)

At any given moment, you only exercise those options, where you expect to get the greatest net profit. If the value generated by an option exceeds how much it costs you to do what it represents, then you do it. As a result, you make money.

Because you have limited resources, you only choose to buy the real options you can afford at that moment. Naturally, you only choose to buy options that are independent of one another at that moment. You can also sort your options based on the attractiveness of their valuation relative to their cost.

If you choose one option, then a number of related options become worthless. For example, if you choose to become a red raincoat specialist, you won’t be attractive to an army purchaser who want their soldiers to be camouflaged. Ouch.

As the environment changes, you can recalculate the values of each option. Note that the value of an option may increase or decrease because of factors completely beyond your control, such as a disruptive technical innovation. Volatility is an input into calculating the value of a real option, so it’s taken into account as your environment changes.

This is a crucial insight into what real options give you. By nature, people prefer to be wrong than to be uncertain. This human tendency screws up many decisions. It forces decisions which aren’t needed yet. It’s better to keep track of options until either they are worthless, or you are certain that they will generate net profit profit.

non.alcoholic.vodka

Real options prevent “vodka and red bull” thinking, often arising during tense strategic negotiations, as they help you wait until it’s pretty clear that a particular alternative is the best one possible.

Thanks to real options, anyone in your company can use a bit of spreadsheet magic, based on numbers which other people in their company know, and determine the best possible strategy. All information is embedded into the assumptions which feed data into the formulas. Of course, this information needs to be shared across departments. Like many analytic exercises, calculating strategic real option values helps build bridges across departmental boundaries.