Assessing Strategic Alternatives

Real Options

Summary of Real Options. Abstract

Timothy A. Luehrman

Real options capture the value of managerial flexibility to adapt decisions in response to unexpected market developments. Companies create shareholder value by identifying, managing and exercising real options associated with their investment portfolio. The real options method applies financial options theory to quantify the value of management flexibility and leverage uncertainty in a changing world.

The idea of treating strategic investments as financial options was brought forward by Timothy A. Luehrman in two Harvard Business Review-articles: "Investment Opportunities as Real Options: Getting Started on the Numbers" (July-August 1998) and "Strategy as a Portfolio of Real Options" (September-October 1998). In the last article Luehrman says: "In financial terms, a business strategy is much more like a series of options than a series of static cash flows".

As a result, in valuations that involve significant future flexibility and/or uncertainty is involved and/or future cash-flows alone are close to break-even, such as long-term strategic scenario's, flexibility has become a major source of value and option (real options) value must be taken into consideration then.

Formula used is Black-Scholes or other similar. Generally, the following variables determine the value of having (an) option(s) - option value:

Time to expiration (duration)
Degree of uncertainty
Cost of acquiring the option(s)
Potential cashflows lost compared to full upfront commitment
Risk-free interest rate
Expected present value of future cashflows

By introducing these factors into business decision-making, the real options method has enabled corporate decision-makers to leverage uncertainty and limit downside risk.

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