Using real options for decision making

A real option refers to the decision alternatives available for a tangible asset. A business can use the real options concept to examine a range of possible outcomes, and then make a choice based on this broad set of alternatives. For example, a traditional investment analysis in an oil refinery would probably use a single price per barrel of oil for the entire investment period, whereas the actual price of oil will likely fluctuate far outside of the initial estimated price point over the course of the investment. An analysis based on real options would instead focus on the range of profits and losses that may be encountered over the course of the investment period as the price of oil changes over time.

A comprehensive real options analysis begins with a review of the risks to which a project will be subjected, and then models for each of these risks or combinations of risks. To continue with the preceding example, an investor in an oil refinery project could expand the scope of the analysis beyond the price of oil, to also encompass the risks of possible new environmental regulations on the facility, the possible downtime caused by a supply shutdown, and the risk of damage caused by a hurricane or earthquake.

A logical outcome of real options analysis is to be more careful in placing large investment bets on a single likelihood of probability. Instead, it can make more sense to place a series of small bets on different outcomes, and then alter the portfolio of investments over time, as more information about the various risks becomes available. Once the key risks have been resolved, the best investment is easier to discern, so that a larger “bet the bank” investment can be made.

A concern with using real options is that competitors may be using the same concept at the same time, and may use the placing of small bets to arrive at the same conclusions as the company. The result can be that several competitors will enter the same market at approximately the same time, driving down the initially rich margins that management may have assumed were associated with a real option. Thus, the parameters of real options constantly change, and so must be re-evaluated at regular intervals to account for changes in the environment.

Another concern relates to the last point, that competitors may jump into the same market. This means that a business cannot evaluate the results of its options analyses in a leisurely manner. Instead, each option must be evaluated quickly and decisions made to make additional investments (or not) before the competition gets a jumps on the situation.

For example, an agriculture company wants to develop a new crop strain for either wheat or barley, to be sold for export. The primary intended market is an area in which wheat is currently the preferred crop. The company estimates that it can generate a 20% return on investment by developing a new wheat variant at a cost of $30 million. Since wheat is already the primary type of crop being planted, the odds of success are high. However, if the company can successfully develop a barley variant at a total cost of $50 million, its projected profits are 50%. The key risk with the barley project is farmer acceptance. Given the high profits that could be derived from selling barley, the company makes a small initial investment in a pilot project. If the level of farmer acceptance appears reasonable, the company can then invest an additional $8 million for a further roll out of the concept.

This use of real options allows the company to invest a relatively small amount to test its assumptions regarding a possible alternative investment. If the test does not work, the company has only lost $1 million. If the test succeeds, the company can purse an alternative that may ultimately yield far higher profits than the more assured investment in wheat.