The new New Economy Analyst
Report – Dec 28, 2001
Juergen Daum’s new New
Economy Best Practice service
©2001 Juergen Daum. All rights reserved.
How to create value with Real Options based
innovation management
News categories: value based management,
strategic enterprise management, R&D and Innovation Management,
A study for the chemical
industry, conducted by Baruch Lev,
Professor of Accounting and Finance with the Stern School of Business at New
York University, revealed, that R&D investments of 83 chemical companies
over a span of 25 years returned 17%
after tax, whereas capital spending earned just the cost of capital of
8%. These findings are important, because they reveal a general pattern in the
developed economies: financial or traditional capital investments (such as in
physical assets) are yielding across all industries today only a return that
earns at best the the cost of capital. To create value added, companies have to
invest in innovation activities, such as in R&D and Product development and
in related intangibles.
So it is no wonder, that
the trend that the business sector funds and performs an increasing share of
R&D in the developed economies, has accelerated in the 1990s. This trend is
confronting today more and more companies with the need to bet larger and
larger amounts of money on innovation projects in the area of research and
development. The pharmaceutical industry and oil companies are used to this
since decades with gigantic amounts of money flowing today into only one drug
development or exploration project. The problem is the uncertainty and the risk
associated with these investments.
When a pharmaceutical
company starts to develop a new compound, it does not know, if really a new
marketable drug will come out at the end of the project. But opportunities and
risks are tightly linked with each other. And this is specifically true for
innovation investments. The higher the risk, the higher also the possible
return. We know this from stock options valuation. And the value of a stock
option can be exponentially increased, if you are able to limit the downside,
the inherent risk. So why not apply the concept of financial options to
so-called real options ? To “real” options, that are generated through a
companies innovation activities, which creates the option to sell a “real” new
product or service to the market in the future, after the development process
has been successfully finished.
The real power of Real options to manage risks and opportunities in the innovation chain
A human intelligence
management expert recently told me, that the human brain systematically
overestimates small risks and underestimates large risks. At the same time we
tend to be much more sensitive to losses than to gains. We would do much more
to avoid a small loss than to make a major gain. So our mental patterns may
become especially a problem for managers and executives in the New Economy,
where the capability of their companies to leverage opportunities and manage
risks have become probably the main economic value drivers. These managers
therefore need tools that help them to evaluate opportunities and risks based
on hard facts instead on “gut feeling. They need new business controlling tools
to aid and support them in their strategic decision making process. The concept
of real options management and valuation may just be the solution.
What are real options ?
The real options
concepts is based on the model for financial options developed by Fischer Black
and Myron Schools in the 1973. The Black and
Scholes Option Pricing Model is an approach for calculating the value of
financial options. These are rights to buy or sell financial instruments such
as stocks, bonds and commodities at a specified price (“the strike price”)
before a specified date (the “expiration date”). It allows investors to make
better investment decisions, because it allows them to make better estimations
about the value of an investment in keeping an option open – which is the
investment into a financial option.
The concept of real
options is using the same principles to value investment opportunities not in
financial markets but in real markets – the markets for products and services.
Real options can be seen therefore as opportunities to invest in, or liquidate
a business’s “real” option to sell new products or services in the future as a
result of a successful innovation and development process. They result from
management’s ability to change and optimize R&D activities over time as new
information become available or as uncertainties are resolved. They are
exercised through management’s strategic choices.
Many strategies can be
enhanced over time if they prove to be successful in ways that only become
apparent as time goes by. Additionally, many investments can be made in stages,
retaining flexibility to respond to future conditions. This flexibility is
inherently valuable. In increases the upsides and limits the downside of
strategies, enhancing their values.
Example: decision tree analysis
to help a pharmaceutical company to decide, whether to invest in a new drug or
not
The concept of real
options valuation (ROV) tries to leverage and value this flexibility inherent
in many especially intangible based innovation strategies. Several ways exist
to value real options. One is the decision tree approach. Here an example for
how it can be used to help a pharmaceutical company decide whether or not to
invest in a clinical trial of a new drug, that is: whether to invest into a new
product innovation project1:
The clinical trial that
was considered was the first in a series of three trials that would be
necessary to verify the drug’s efficiency. If the drug made it through the
three clinical trials, it would then have to be reviewed by the FDA for final
approval. Based on scientific evidence
and academic research, the probabilities of passing each of the three phases
were 75%, 50% and 65% respectively. The FDA approval probability, assuming it
had passed the trials, was 85%. The estimation of the costs of the entire trial
and approval process would be $23 million. Given all this information about
risks and costs, what can us now tell the real option valuation about if the
company should proceed with the clinical trials or not ? The equation according
to the decision tree analysis method goes as follows:
First you create a
decision tree incorporating all possible outcomes of future trials and all of
management’s decisions in each event. Then the net present value (NPV) of each
possible “end state” is calculated
using the standard discounted cash flow (DCF) model. Then starting with the
final year of the evaluation phase and working backwards, the assumption is,
that management chooses the highest NPV alternative at each decision point.
This process clarifies whether or not it makes sense to abandon, re-trial or
proceed should any of the trials fail. As figure 1 is showing, it turned out to
be optimal to reformulate if the first trial phase failed, repeat the second
trial phase if it failed, and abandon the drug if the third trial phase failed.
To calculate now the NPV for the phase 1 trial, one has to eleminate the
(unchosen) lower NPV scenarios to arrive at an adjusted NPV of $ 9.3 million
(75% x 13.2 + 25% x –2.5).
Figure 1: Decision tree analysis for the clinical trial of
a new drug (source: L.E.K. /
www.lek.com)
Compared with a simple DCF analysis, which is
not using the decision tree and is resulting in a negative NPV of -$1.8 million2,
the value of the decision tree valuation is significant higher because it
recognizes the value of the real options consisting in the flexibility of
management to choose at each decision point (in the event of failure in the
respective phase) the one of the remaining options that has the highest NPV
value.
Such a decision tree analysis is an interesting
method to value staged investments with multiple options to abandon as it is
typical for the product innovation process of a company. The value of these
investments can only be understood and captured by considering both current and
potential future decisions. By identifying optimal responses to future
contingencies before they occur, management can gain clarity about how and when
to make future investment decisions which is greatly reducing the likelihood of
making a bad decision. So the decision tree valuation is a good tool to value
scenarios concerning investments decisions that refer to investments into
product innovation and should therefore be used to support the strategic
management process of an organization that is investing significantly into
product innovation.
Other methods to value real options include the
binomial model and the Black-Scholes approach. The binomial model incorporates
all of the factors that impact option values by assuming that one of two
outcomes occur in each period: an upside or a downside. So it is limited to two outcomes per period,
but corrects the discount rate imprecision of the decision tree approach,
because it values options by forming a risk-free “twin” portfolio from which
the outcomes can be discounted using the risk-free rate. The Black-Scholes
approach offers the most precise quantification of real options value for
public companies where volatilities can be determined from their stock prices.
It incorporates all the factors that impact option values. It is the best
choice to value simple options that arise from a single, market-priced source
of risk and are exercised at maturity (for an example for a ROV based on the
Black & Scholes approach see the reference to “The McKinsey Quarterly”
under the section “Additional resources”).
Summary
Companies will have to invest more and more
money in innovation and R&D in the future. Research and development are the
activities that generate, beside the creation of tight relationships with
customers, most of the value in today’s Intangible based economy, because the
engagement in innovation and product development generates opportunities for
future revenues and growth. Because these investments are growing larger and
larger, the risk, if a development projects is failing, have become also huge.
Because
human beings (and therefore also managers) systematically overestimates small
risks and underestimates large risks and at the same time tend to be much more
sensitive to losses than to gains, managers therefore need tools that help them
to evaluate opportunities and risks based on hard facts instead on “gut
feeling”. Only this way, there are able to successfully leverage opportunities
and manage risks, a capability which probably has become on of the main
economic value drivers in the New Economy. They therefore need new business
controlling tools to aid and support them in their strategic decision making
process. The concept of real options management and valuation may just be the
solution, because it helps to create an more objective basis for the decision to invest at all in a product innovation path,
to continue with it or to abandon it.
But as helpful real options are to demonstrate
the value of flexibility, if the inputs remain too uncertain, the output may be
of no value. So only if proper forecasting data is available and only if this
forecasting data is updated over time (for example in the context of the
strategic management process), then it should be used to calculate real option
values. But even when the models do not result in precise values, there is
another possibility to use them: you can use the models to back-solve for what
the inputs would have to be to justify a given value – for example to calculate
the amount of investments that have to be made in order to justify the value of
a business unit or an entire company that is engaged in constant product
innovation. But perhaps the main benefit from applying real options is the
managerial mindset it creates. Understanding that flexibility is valuable leads
managers to identify options to expand, defer, switch, or contract operations
that before would have expired unexercised. It lead executives to move from
putting all their eggs in one basket and fixating on “most likely” scenarios to
pursuing several paths at once, investing in stages, and making decisions to
increase flexibility going forward. This results in an enhanced ability to
adapt to new situations and opportunities and increased shareholder and
stakeholder value.
Footnotes:
1
This example has been described by L.E.K. Consulting LLC in its newsletter series “Shareholder Value Added”,
volume XVI, Making Real Decisions with
Real Options. The newsletter can be obtained at www.lek.com
2
the calculation goes like this: first you calculate overall probability of
success (75% x 50% x 80% x 83% = 25%) and of failure(100% - 25% = 75%) and then
the DCF value itself (25% x $62 million + 75% x -$23.1 million = -$1.8 million)
Additional resources:
The Black &
Scholes option pricing model
Option Price Calculator based on
the Black & Scholes concept (at the bottom of this page)
Previous new New
Economy Analyst reports related to this topic:
Nov 13, 2001 - Interview
with Leif Edvinsson: Intellectual Capital: the new wealth of corporations
July 26, 2001 - How
accounting gets more radical in measuring what really matters to investors
July 18, 2001 - Interview
with David P. Norton: "Intangible Assets and the Balanced Scorecard"
I will continue in
future reports to report on issues related to managing companies in our
information and Intangible Assets based economy of today. To subscribe for my free-of-charge
e-mail newsletter click here.
The concept for a new
accounting, controlling, and management system for knowledge and intangible
assets based businesses, that integrates strategy management (strategic
innovation) and product and market development (product and market innovation)
with operations management (supply chain management, customer relationship
management) and resource management (finance, hr, alliances, IT) is described
in detail in my forthcoming book "Intangible Assets oder die
Kunst, Mehrwert zu schaffen" ("Intangible Assets or the Art to Create
Value ").
©2001
Juergen Daum. All rights reserved.
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