Uncertainty is the greatest risk a manager faces. Managers who make strategic decisions often view uncertainty as costly. However, uncertainty provides the greatest opportunity for creating value. The concept of real options provides a way of thinking that can help managers balance the risk of potential payoffs when making decisions in an uncertain world.
To understand real options, one must ask what an option is. An option is the right, but not the obligation, to take an action in the future. Options are valuable when there is uncertainty. One option contract traded on the exchange gives the buyer the opportunity to buy a stock at a specified price on a specified date and will be exercised (used) only if the price of the stock on that date exceeds the specified price.
Since many investments create opportunities that may or may not be taken, the opportunities can be viewed as a stream of cash flow plus a set of option. Hence real options are a financial concept borrowed from financial options, applied to investment and business decisions in non-financial, real assets like infrastructure, technology, or projects. Real options help organizations assess and manage uncertainty by giving them “decision checkpoints” where they can expand, defer, modify, or abandon a project based on a new information.
The introduction of real options theory is a way of thinking. It provides an immediate and important perspective on value creation in an uncertain world. Real options address the gap between strategic planning and finance. The real options approach expands the set of strategic alternatives managers consider.
There are three components. Options are contingent decisions. It is an opportunity to make a decision after you see how events unfold. The payoffs to an option are nonlinear which changes with your decision.
Options valuations are aligned with financial market valuations. The approach uses financial market inputs and concepts to value complex payoffs across all types of real assets. This results to symmetrical comparison of transaction opportunities.
Options thinking can be used to design and manage strategic investment proactively. The nonlinear payoffs can also be a design tool. The manager can look at how to reduce exposure to uncertainty. The possibility of increasing the payoff with a good outcome can be explored.
We list some examples and illustrations of real options.
The option to defer is the choice to delay an investment until more information becomes available. Imagine a company considering building a new factory to produce a product with uncertain demand. The company could defer the investment until market demand becomes clearer. This flexibility reduces the risk of investing in an unsuccessful product and allows the company to react to new market insights before making a substantial financial commitment.
Once an initial project is successful, a business might have the option to scale or expand it. For example, a mining company might invest in a small-scale exploratory drilling operation. If they discover a substantial mineral deposit, they have the option to expand their operations. This option was embedded in their initial decision, giving them an avenue to grow their investment should initial results prove positive.
Some projects allow companies to scale down or abandon operations if they become unprofitable. Imagine an airline investing in a new route. If demand for the route turns out to be lower than expected, the airline can reduce flight frequency or even cancel the route, thereby limiting losses. This option is valuable where demand is highly unpredictable.
The option to switch refers to the ability to switch inputs, outputs, or operating modes in response to changing conditions. A utility company, for example, might have a power plant that can switch between natural gas and coal depending on which fuel is cheaper or more abundant. By embedding this option, the utility can reduce operating costs in response to fluctuating fuel prices.
When there’s an opportunity to invest but the current market conditions are poor or uncertain, a company may choose to wait before proceeding. For example, a real estate developer considering a project in an economically uncertain region may wait until economic indicators improve. This delay minimizes the downside risk if conditions worsen while keeping the option open to proceed if the outlook becomes favorable.
Real options contribute to decision-making in project valuation, risk management, building strategic flexibility, creating competitive advantage, and facing an uncertain environment. Value is added by acknowledging the flexibility to make decisions over time. Companies can limit their exposure to unfavorable outcomes. Real options help avoid premature commitments. They will allow the company to react and adapt to fast-changing conditions.
Real options in decision-making processes make companies gain a structured yet flexible approach to managing risks, seizing opportunities, and navigating uncertainty. The ability to pivot and optimize investments can be critical to long-term success.
(Benel Dela Paz Lagua was previously EVP and Chief Development Officer at the Development Bank of the Philippines. He is an active FINEX member and an advocate of risk-based lending for SMEs. Today, he is independent director in progressive banks and in some NGOs. The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as FINEX.)