STRATEGY AND SHAREHOLDER VALUE CREATION: THE REAL OPTIONS FRONTIER

The current interest in real options reflects the dramatic increase in the uncertainty of the business environment. Viewed narrowly, the real options approach is the extension of financial option pricing models to the valuation of options on real (that is, nonfinancial) assets. More broadly, the real options approach is a way of thinking that helps managers formulate their strategic options—the future opportunities that are created by today's investments—while considering their likely effect on shareholder value. But if the real options framework promises to link strategy more closely to shareholder value creation, there are some major challenges on the frontier of application. In the first part of this paper, the authors tackle the question, “What is really new about real options, and how does the approach differ from other wellestablished ways to make strategic decisions under uncertainty?” This article provides a specific definition of real options that relies on the ability to track marketpriced risk. Using examples from oil exploration and pharmaceutical drug development, the authors also show how specific features of the industry and the application itself determine the usefulness of the real options approach. The second part of the paper addresses the question: Given the many differences between real and financial options, how should a real options application be framed? The authors examine the use of real options in the valuation of Internet companies to demonstrate the required judgment and tradeoffs in the framing of real options applications. The case of Webvan, an online grocer, is used to illustrate the inter‐action between strategy, execution, and valuation.     

THE PROMISE OF REAL OPTIONS

In recent years, both practitioners and academics have argued that traditional discounted cash flow models do a poor job of capturing the value of the options embedded in many corporate actions. This paper shows how option pricing models used in valuing financial assets can be used to value three kinds of real options that are often built into corporate projects: the option to delay, the option to expand, and the option to abandon. As a number of examples in this paper suggest, corporate investments that would be rejected using conventional DCF analysis can sometimes be justified by the value of the strategic options they provide. As the illustrations also show, however, the pricing of real options is considerably more difficult than the pricing of financial options and adjustments must often be made to capture the complexity of real investments.     

Stop making plans; start making decisions

Many executives have grown skeptical of strategic planning. Is it any wonder? Despite all the time and energy that go into it, strategic planning most often acts as a barrier to good decision making and does little to influence strategy. Strategic planning fails because of two factors: It typically occurs annually, and it focuses on individual business units. As such, the process is completely at odds with the way executives actually make important strategy decisions, which are neither constrained by the calendar nor defined by unit boundaries. Thus, according to a survey of 156 large companies, senior executives often make strategic decisions outside the planning process, in an ad hoc fashion and without rigorous analysis or productive debate. But companies can fix the process if they attack its root problems. A few forward-looking firms have thrown out their calendar-driven, business-unit-focused planning procedures and replaced them with continuous, issues-focused decision making. In doing so, they rely on several basic principles: They separate, but integrate, decision making and plan making. They focus on a few key themes. And they structure strategy reviews to produce real decisions. When companies change the timing and focus of strategic planning, they also change the nature of senior management's discussions about strategy--from "review and approve" to "debate and decide," in which top executives actively think through every major decision and its implications for the company's performance and value. The authors have found that these companies make more than twice as many important strategic decisions per year as companies that follow the traditional planning model.     

Value-Based Management in Biosciences Research and Development

In industries such as biosciences, the range of uncertainty and managerial flexibility make traditional financial analysis such as discounted cash flow and decision tree analysis largely irrelevant for strategic decision-making. In place of such traditional methods, this article proposes the use of decision options analysis, a real-options-based methodology that holds out the promise of better investment and portfolio decisions with fewer data requirements. Moreover, decision options analysis can be implemented with software tools that allow systematic application of these techniques. This article presents case studies that outline the actual application of real options analysis in licensing transactions and portfolio management in biosciences companies.     

Strategy under uncertainty

At the heart of the traditional approach to strategy lies the assumption that by applying a set of powerful analytic tools, executives can predict the future of any business accurately enough to allow them to choose a clear strategic direction. But what happens when the environment is so uncertain that no amount of analysis will allow us to predict the future? What makes for a good strategy in highly uncertain business environments? The authors, consultants at McKinsey & Company, argue that uncertainty requires a new way of thinking about strategy. All too often, they say, executives take a binary view: either they underestimate uncertainty to come up with the forecasts required by their companies' planning or capital-budging processes, or they overestimate it, abandon all analysis, and go with their gut instinct. The authors outline a new approach that begins by making a crucial distinction among four discrete levels of uncertainty that any company might face. They then explain how a set of generic strategies--shaping the market, adapting to it, or reserving the right to play at a later time--can be used in each of the four levels. And they illustrate how these strategies can be implemented through a combination of three basic types of actions: big bets, options, and no-regrets moves. The framework can help managers determine which analytic tools can inform decision making under uncertainty--and which cannot. At a broader level, it offers executives a discipline for thinking rigorously and systematically about uncertainty and its implications for strategy.     

Human capital investment and optimal portfolio choice

We analyze how an individual should optimally invest in human capital when he also has financial wealth. We treat the individual's possibilities to take more education as expansion options and apply real option analysis. In addition, we characterize the individual's optimal consumption strategy and portfolio weights. The individual has a demand for hedging financial risk, labor income risk, and also wage level risk.     

Martingales and Portfolio Decisions: A User’s Guide

This article gives an overview and introduction to the Martingale approach to multi-period (dynamic) portfolio decisions. While Martingale pricing techniques have long been used with considerable success in the pricing of derivatives and financial assets in general, their potential to improve the practice of dynamic portfolio decisions is not sufficiently recognized yet. This article shows that the approach is, in principle, not difficult to implement for readers equipped with standard option replication techniques if markets are sufficiently “complete” in order to provide investors with the relevant information about the pricing of financial risks. The article provides a practical guide to implement the basic features of the approach in a binomial framework.     

The duration of option portfolios

Duration is a value-weighted measure of average maturity which is commonly associated with portfolios of fixed-income securities. However, the concept finds application in option pricing theory also. This article shows that if options are valued by the Black (1976) formula and a comparative-statics methodology is employed, then the interest rate sensitivity of a portfolio of European options is equal to its duration. If the options are instead valued through the Black-Scholes (1973) formula, then the interest rate sensitivity is equal to only the ‘bond-equivalent duration’ inherent in a dynamic replication strategy for the option portfolio.     

Learning risk preferences from investment portfolios using inverse optimization

The level of risk an investor can endure, known as risk-preference, is a subjective choice that is tightly related to psychology and behavioral science in decision making. This paper presents a novel approach of measuring risk preference from existing portfolios using inverse optimization on mean–variance portfolio allocation framework. Our approach allows the learner to continuously estimate real-time risk preferences using concurrent observed portfolios and market price data. We demonstrate our methods on robotic investment portfolios and real market data that consists of 20 years of asset pricing and 10 years of mutual fund portfolio holdings. Moreover, the quantified risk preference parameters are validated with two well-known risk measurements currently applied in the field. The proposed methods could lead to practical and fruitful innovations in automated/personalized portfolio management, such as Robo-advising, to augment financial advisors’ decision intelligence in a long-term investment horizon.     

Strategic technology adoption and hedging under incomplete markets

We investigate the implications of technological innovation and non-diversifiable risk on entrepreneurial entry and optimal portfolio choice. In a real options model where two risk-averse individuals strategically decide on technology adoption, we show that the impact of non-diversifiable risk on the option timing decision is ambiguous and depends on the frequency of technological change. Compared to the complete market case, non-diversifiable risk may accelerate or delay the optimal investment decision. Moreover, strategic considerations regarding technology adoption play a central role for the entrepreneur’s optimal portfolio choice in the presence of non-diversifiable risk.     

CFO Fiduciary Responsibilities and Annual Bonus Incentives

We examine how firms design bonus plans of their CFOs. CFOs participate in decision making much like other executives, but they also have significant fiduciary responsibilities for reporting firms' financial results. Responsibility for financial reporting raises the question of whether it is appropriate to pay CFOs annual bonuses contingent on self-reported financial performance. In this paper, we provide a framework that characterizes CFO bonuses as a tradeoff between CFOs' decision-making responsibilities and their fiduciary duties over financial reporting. This framework yields a number of implications that we examine empirically using a proprietary survey of CFO compensation practices of public and private firms. Our main finding shows that from 2003 to 2007 public entities (relative to private entities) reduced the percentage of CFO bonuses contingent on financial performance. We interpret this result as evidence that firms mitigate misreporting practices in part by deemphasizing CFO incentive compensation.     

OPTION EXERCISE GAMES: THE INTERSECTION OF REAL OPTIONS AND GAME THEORY

While the real options approach has proven useful in providing an analytical framework for analyzing the timing of investment decisions, a notable failure of the approach has been an almost complete lack of strategic considerations. In standard real options models, invest-ment (and exercise) strategies are for-mulated in isolation, without considering the potential impact of other firms' exercise strategies. This paper illustrates how the intersection of real options and game theory provides powerful new insights into the behavior of economic agents under uncertainty.
Introducing strategic considerations into the real options framework can lead to a rethinking of standard real option analysis. For example, one of-ten cited conclusion of the real options literature is the overturning of the standard capital budgeting rule of in-vesting immediately in any project with a positive NPV. Because the fu-ture value of the asset is uncertain, there may be significant benefits to deferring the investment until condi-tions prove even more favorable. But this result clearly depends on the lack of competitive access to the project. If firms fear preemption, then the option to wait becomes less valuable. For example, while the standard real op-tions models suggest that a real estate developer should wait until the devel-opment option is considerably "in the money," competition and the fear of preemption will likely force develop-ers to build much earlier.     

The Strategic Options of Supreme Audit Institutions: The Case of Four Nordic Countries

Based on the theory of professional competition, this paper identifies and investigates four strategic options of supreme audit institutions (SAIs) through a case study of four Nordic national audit offices: a performance auditing strategy; a financial auditing strategy; a portfolio strategy; and a hybrid strategy. The analysis of the Nordic SAIs shows that while one SAI appears to have adopted a hybrid strategy, the portfolio strategy has been chosen by the three other SAIs, although with some variations in the portfolio. The paper concludes by discussing the implications of these strategic options for public sector auditing.     

HOW TO USE EVA IN THE OIL AND GAS INDUSTRY

The use of EVA in the oil industry has lagged behind that in most other industries because the accounting information reported by oil and gas concerns does such a poor job of representing management's effectiveness in adding value for shareholders. The essence of the problem is that the exploration activities of oil companies create assets whose changes in value are recognized by the stock market long before they are reflected on income statements or balance sheets. As a result, all accountingbased performance measures, including generic measures of EVA (which are derived from accounting information), fail to provide meaningful goals, decision tools, or compensation benchmarks.
This article provides a new, EVAbased framework for performance measurement and incentive compensation for oil and gas firms—and for companies in extractive industries in general. The authors show that, when adjusted by a publicly available measure of hydrocarbon reserve value known as "SEC-10," EVA's ability to explain annual stock returns rises from under 10% to almost 50%. Moreover, because SEC-10 has several important limitations as a measure of reserve value, there is considerable additional room for improving EVA's explanatory power. And the actual implementation of an EVA financial management system for an individual oil company can and should be based on more precise estimates of reserve value than those provided by SEC-10.
To this end, the authors provide an approach to hydrocarbon reserve valuation that captures the "real option" value of undeveloped reserves. By incorporating real option values, this new EVA financial management system for oil companies aligns management's incentives with the goal of creating shareholder wealth by rewarding managers for creating real option value as well as current cash flow—and by forcing managers to consider the optimal "exercise" of such strategic options.     

A METHOD FOR ESTIMATING GLOBAL CORPORATE CAPITAL COSTS: THE CASE OF BESTFOODS

The financial management practices of many multinational corporations are at odds with both financial theory and the strategic case for global expansion. Despite the weight of academic literature, many financial executives still cling to ad hoc rules of thumb that discourage value-enhancing global growth. In particular, they tend to require large risk premiums for making foreign investments while ignoring the diversification benefits of such investments for their shareholders.
This article presents a practical method for estimating the cost of capital for use by multinationals both in evaluating foreign investment opportunities and in measuring the ongoing performance of overseas business units. The method represents a kind of "hybrid" version of the global CAPM—one that attempts to reconcile some of corporate executives' concerns about the distinctive risks of foreign investment with the finance theorist's portfolio perspective and reliance on capital market information. More specifically, the framework uses information from capital markets to determine the appropriate risk premiums for currency and sovereign risks associated with each country in an MNC's portfolio. But, at the same time, these risk premiums are partly offset by taking account of any diversification benefits that foreign investment provides for the firm's shareholders.
The method is illustrated using the case of Bestfoods, a Fortune 200 company with extensive overseas operations that recently adopted the method. For the purpose of evaluating new projects, Bestfoods produces quarterly updates of its cost-of-capital estimates for each country in which it has (or expects to have) major operations. For evaluating the ongoing performance of each country business unit, the relevant cost of capital is calculated annually (at the beginning of each fiscal year).     

The chief strategy officer

They're nominally and ultimately responsible for strategy, but today's CEOs have less and less time to devote to it. As a result, CEOs are appointing "chief strategy officers"--executives specifically tasked with creating, communicating, executing, and sustaining a company's strategic initiatives. In this article, three authors from Accenture share the results of their research on this emerging organizational role. The typical CSO or top strategy executive is not a pure strategist, conducting long-range planning in relative isolation. Most CSOs consider themselves doers first, with the mandate, credentials, and desire to act as well as advise. They are seasoned executives with a strong strategy orientation who have usually worn many operations hats before taking on the role. Strategy executives are charged with three critical jobs that together form the very definition of strategy execution. First, they must clarify the company's strategy for themselves and for every business unit and function, ensuring that all employees understand the details of the strategic plan and how their work connects to corporate goals. Second, CSOs must drive immediate change. The focus of the job almost always quickly evolves from creating shared alignment around a vision to riding herd on the ensuing change effort. Finally, a CSO must drive decision making that sustains organizational change. He or she must be that person who, in the CEO's stead, can walk into any office and test whether the decisions being made are aligned with the strategy and are creating the desired results. When decisions below the executive suite aren't being made in accordance with strategy, much of the CSO's job involves learning why and quickly determining whether to stay the course or change tack.     

Portfolio Selection and Asset Pricing Models

Finance theory can be used to form informative prior beliefs in financial decision making. This paper approaches portfolio selection in a Bayesian framework that incorporates a prior degree of belief in an asset pricing model. Sample evidence on home bias and value and size effects is evaluated from an asset-allocation perspective. U.S. investors' belief in the domestic CAPM must be very strong to justify the home bias observed in their equity holdings. The same strong prior belief results in large and stable optimal positions in the Fama–French book-to-market portfolio in combination with the market since the 1940s.     

Risk measure pricing and hedging in incomplete markets

This article attempts to extend the complete market option pricing theory to incomplete markets. Instead of eliminating the risk by a perfect hedging portfolio, partial hedging will be adopted and some residual risk at expiration will be tolerated. The risk measure (or risk indifference) prices charged for buying or selling an option are associated to the capital required for dynamic hedging so that the risk exposure will not increase. The associated optimal hedging portfolio is decided by minimizing a convex measure of risk. I will give the definition of risk-efficient options and confirm that options evaluated by risk measure pricing rules are indeed risk-efficient. Relationships to utility indifference pricing and pricing by valuation and stress measures will be discussed. Examples using the shortfall risk measure and average VaR will be shown. The work of Mingxin Xu is supported by the National Science Foundation under grant SES-0518869. I would like to thank Steven Shreve for insightful comments, especially his suggestions to extend the pricing idea from using shortfall risk measure to coherent ones, and to study its relationship to utility based derivative pricing. The comments from the associate editor and the anonymous referee have reshaped the paper into its current version. The paper has benefited from discussions with Freddy Delbaen, Jan Večeř, David Heath, Dmitry Kramkov, Peter Carr, and Joel Avrin.     

Managerial flexibility and the wealth effect of new product introductions

This paper examines whether investors recognize the value of managerial flexibilities, as proxied by real options, in their valuation of new product introductions. We define a firm’s real options portfolio as the difference between the firm’s market value and its assets in place. A firm’s strategic flexibilities are modeled as the ratio of its real option portfolio to its book value. Using a sample of new product introductions from 1998–2007, we find our real options measure is positively related to announcement period abnormal returns. This result holds after we control for other variables known to be correlated with the announcement effect in previous studies. Our result is robust to alternative measures of real options based on analysts’ earnings expectations and whether a firm has one or multiple segments. In summary, our results suggest that a firm’s perceived strategic and operating flexibilities are an important factor in the valuation of new products.     

Valuing an Early‐Stage Biotechnology Investment as a Rainbow Option

In an article published in this journal in 2003, Richard Shockley and three of his students presented a detailed valuation of an early‐stage biotechnology investment using a binomial lattice option pricing model. The article demonstrates how investments with multiple stages can be treated as “compound sequential options”—that is, as series of options in which investments in one option provide the opportunity to invest in the next in the series. In this article, the author uses the same business case analyzed by Shockley et al. to demonstrate how to value this early‐stage biotechnology investment by separately modeling the two types of risks: technology and product market. An option that has two distinct kinds of risk that develop differently over time is known as a “rainbow option.” The key adjustment to the option pricing model required to value such an option is that, instead of the standard binomial option pricing model with two outcomes at each point in time, the author uses a “quadranomial” option pricing model with four outcomes at each point in time. By distinguishing technology risks from product market risks and allowing them to develop differently over time, the author's analysis leads to a very different valuation and, indeed, a different decision about the initial investment than the one produced by Shockley's model.