Real Options (Luehrman)

Treating strategic investments as financial options. Explanation of Real Options of Timothy A. Luehrman. ('98)

What are Real Options? Description

Real Options capture the value of managerial flexibility to adapt strategic decisions in response to unexpected market developments. A company creates shareholder value by identifying Real Options, managing of Real Options, and exercising Real Options, associated with its investment portfolio. The Real Options method applies financial options theory to quantify the value of management flexibility, thus turning uncertainty to its advantage in a changing world.

The idea of treating strategic investments as financial options was conceived by Timothy A. Luehrman in two HBR 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".

Use of Real Options. Benefits

As a result of the above, when valuations involve significant future flexibility or uncertainty and/or future cash-flows alone are close to break-even, flexibility is a major source of value, and option value must be taken into consideration. Note that the first mentioned circumstance is typical for strategic scenarios. And even for strategic decision-making in general.

Formula of Real Options. Calculation

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 cash flows lost, compared to full upfront commitment.
Risk-free interest rate.
Expected present value of future cash flows.

By introducing these factors into business decision-making, the Real Options method has enabled corporate decision-makers to use uncertainty for the advantage of the firm, and to create a limit to downside risk.