The real options approach is a method of evaluating and managing strategic investments in an uncertain business environment. Based on academic research by economists Fischer Black, Myron Scholes and Robert Merton, the options theory is now widely used on Wall Street. The real options approach extends option pricing tools from financial contracts to real (nonfinancial) assets.
It's no secret that many companies struggle with decisions about technology investments. Executives know that technology is important, but many have difficulty aligning IT spending with business goals. This is particularly true in today's business economy, where markets and companies are being forced to adjust and change at an almost blinding pace. It's hard for anyone to make an informed decision when many variables are in flux and even harder when there's a dearth of decision-support tools.
Unfortunately, ROI and other traditional valuation approaches fall short when IT plays a strategic role in uncertain markets. Think of it this way: Can you predict the next killer app that will emerge from your e-commerce initiative? Of course not, because at this point there are a multitude of possible outcomes. But a traditional ROI analysis requires such a pinpoint forecast - a single future scenario and investment plan. When executives face the prospect of giving a thumbs-up to a big-ticket technology project with such analytical support, it's not surprising that many fall back on gut instinct for guidance.
Traditional tools fail because they neglect to account for the value of flexibility - how managers respond to unfolding events in uncertain markets.
But an emerging valuation approach called real options creates a portfolio of options for IT investments by linking these seeming internal decisions to external financial markets. The real options approach gives executives a set of choices that can be made in the future in response to changing business conditions.
IT decisions are difficult and inherently complex, and the real options approach does not make decisions easier. But this approach does provide a framework for the CIO and line executives to engage in meaningful strategic dialogue, offering the senior executive team a mechanism to manage this business risk over time.
Real Options Defined
The real options approach originates from the research done to price financial option contracts. For example, a call option contract on Lucent Technologies gives the holder the right, but not the obligation, to buy a fixed number of shares of Lucent stock at a specified future date for a specified price. Real options are opportunities that centre on real (non-financial) assets. Real and financial options are valuable because they enable the option holder to take advantage of potential benefits while controlling risk. In essence, options shift the possible distribution of future outcomes toward a more favourable pattern. Buy an option today and make a follow-up investment if the option proves worthwhile. If things don't go well, there is no need for further investment, and the loss is limited to the cost of the initial option.
How do real options work in the business world? Let's take a very simple case of expanding the manufacturing capabilities of an ice cream plant. Suppose that with a bit more manufacturing capacity, a line for seasonal flavours can be added. It's not clear that flavours will be produced in every season or which flavours will be most successful. But installing new production capacity creates the option to learn about the value of seasonal flavours. The upside to this product flexibility option could be large as it creates new markets. The costs of the option are limited to the cost of the extra capacity. The flexibility option allows the company to adapt manufacturing to respond to changing customer demand.
Options thinking highlights two key points. First, risk can be your friend.
Greater market volatility does not translate into greater losses, because losses are limited to the initial investment. But greater volatility does produce greater gains because the option enables you to capture sudden market upswings. With greater volatility, you should be willing to pay more to acquire an option-with all else being equal.
Second, time is on your side. Options thinking shows the value of longer decision horizons. Two-year options allow you to change your mind several times and are more valuable than options that are only three months long.
The real options approach creates a decision-making discipline that emphasises learning and choice. For IT managers, the challenge is to transform this intuitive concept into a workable methodology.
What's the Attraction?
Real options capture the value created by IT investments that deliver platforms of business flexibility in a disciplined manner. For example, let's look at an IT investment to support the ice cream company's growth. Suppose there is already enough computing capacity to grow the business another 25 per cent.
Investing in more computing capacity doesn't have many benefits. But a more valuable IT investment would allow the company to retain business flexibility, such as options to change the current product or to launch new products.
For IT, those options would translate into building systems that are easily modified or extended in response to the company's product changes. For example, a proposed data warehouse might allow rapid application development, which enables the quick addition of new product data to the warehouse. Or the warehouse might feature customised decision support, which would help analysts choose new flavours faster. Such a data warehouse contributes to the product flexibility option and is thus viewed as a worthwhile IT investment. If executives relied on traditional valuation tools that focused on incremental cost reductions or incremental increases in capacity, the benefits of the data warehouse would be less obvious.
Why go to the trouble of adopting a real options approach to IT investments? We think there are four key reasons.
A disciplined process for decision making. A key aspect of the real options approach is discipline. Because options tools were first developed for financial instruments, they carry a market orientation. This means that when executives use options strategy to evaluate IT investments, the model analyses valuation problems by how financial markets think about business opportunities.
It uses market-based data instead of subjective guesses wherever possible.
Since IT investments will increasingly define a company's future business platform, real options gives senior executives a much-needed valuation tool that works in today's uncertain environment.
IT investments that are linked to business risk, not just project risk. Too often we focus on the technology outcomes that will be resolved by the next project. Meanwhile, the value of the project tanks as business conditions change. The real options approach captures both technology and business risk, allowing investment decisions to link up to corporate strategy.
Acquiring the discipline of learning and leadership. When the CIO starts to model future options, he or she is not only articulating the link between IT strategy and business strategy but also establishing the decision points required by the leadership team over time. Investment becomes a responsive and leadership-driven process, not a single-decision event.
Using IT projects to manage business risk. By exposing the business implications of the project, the real options approach provides the IT team an opportunity to design features (like scalability, modularity and open architecture) that help manage the business risk profile.
Many executives will intuitively understand the options characteristics found in IT projects. Investments in data warehouses, for example, create value through the ability to quickly develop new applications. Similarly, an open architecture creates sourcing options for many companies. The challenge, however, is to move beyond intuition to find an efficient and practical way to apply real options thinking to IT investment. We advise managers to start by defining the types of options frequently encountered, which clearly delineates the sources of option value in an IT investment as well as its size and relative importance. With this insight, the executive team can then determine the degree of analysis required to fully detail the proposed alternatives.
Examples from two real IT options may help to illustrate.
Scalability options create opportunities to flexibly adjust to the scale of the business over time. Imagine a company whose strategy requires an aggressive market expansion into Europe and Asia, which will significantly increase the flow of transactions through the supply chain management system. However, the timing and size of the market expansion is uncertain.
In this case, a real options analysis would help decision makers think through the timing of the IT capacity expansion by linking the value of IT investments to the range of possible business outcomes and by identifying the critical levels of key business variables that trigger the next stage of expansion. The real options approach allows executives to fully value the flexibility created by alternative investment strategies and to trade off the value of extensibility against cost.
Flexibility options allow a company to easily and quickly adapt product features or service offerings. In the IT world, new software development tools for e-mail allow mass customisation of electronic commerce advertising and information and lead into personalised services. By investing in these packages, executives acquire an option that represents the opportunity to quickly and effectively make follow-on investments that could not have been achieved without this new business platform.
There are many more real IT options. Their power lies in how technology choices are linked to the delivery of shareholder value and how IT decisions become driven by business conditions.
The need for an approach like this is imperative. Business conditions have changed, and IT is increasingly at the centre. If done right, real options in IT investments can create shareholder value in demonstrable ways. Companies that ask for less in their IT decision process will deliver much less as well.
Six steps to exercising real options at workThe Goldman Sachs Group recently bought approximately 22 per cent of Wit Capital Group, a small, New York City-based Internet investment bank. Goldman also invested $US25 million in Archipelago LLC in Chicago, an electronic communications network (ECN), an alternative trading system to the NYSE and Nasdaq. Goldman uses E-Trade as a distribution channel for IPOs that it sells, and the company is looking at other ways to do business on the Internet. Cheap insurance or a portfolio of options on the future? Goldman is a great company, but it can't predict the future. So the company is taking real options on the Internet by making a number of relatively small Internet bets. No matter how the future turns out on the Net, Goldman will be a winner. These investments have very similar characteristics as financial options. Their low initial cost allows you to defer making the larger investment decision until you know which path will be the winner. Like a venture capitalist, Goldman is counting that one or two winners will pay for all the losers and then some.
To make sure your company's investments will position it for success in the digital economy, follow these six steps: 1. Broaden the way your company looks at technology spending by dividing IT investments into three different categories. Invest in IT infrastructure to streamline operations, connect to the outside world and focus on your customers. Implement traditional ROI projects to keep pace with your competitors in the relentless drive to become faster, better and cheaper.
Finally, use real option investments in IT to ensure that your business can respond quickly and easily to changing business conditions.
2. Perform a diagnostic checkup on your company by mapping your current investments into the three categories (infrastructure, ROI and option creating) and assessing how each of these investments gives you an advantage, puts you at parity or places you behind your competitors.
3. Make new investment decisions in the context of your target portfolio to ensure proper balance and market impact.
4. Conduct a senior management review of your portfolio of option investments once a quarter. Senior management must pay attention if these investments are going to transform your company's business.
5. Change your incentive and reward system. Reward the team that reduces the uncertainty of the option investment rather than the team that gets assigned to the winner in the portfolio. Learn from the losers as well as the winners. The portfolio will win if you explore each option to its fullest.
6. Exercise the winners and abandon the losers. Fall in love with results, not ideas.