A practitioner's notes on real-options analysis

The process

Having led my share of real-options analyses, the key thing to keep in mind is to split the tree into the three key phases of a product - technical, commercial, and users. The key insight for the technical phase is whether the solution will behave as advertised. For commercial, you want to find out if a product will be accepted as part of the BU's portfolio. For the user phase, it is all about how where does it fit within the existing usage landscape.

This then provides a rough guide on what kind of information will be needed and where you can look for the best information. Within each phase, each branch is a discussion point with the relevant experts. And, what I find most revealing is to use simple arithmetic averages as the starting point, i.e. if there are two branches for a node, it would have a probability value of 50% each, then ask the expert to adjust the percentage and why the adjustment.

The critical junctures of the analysis are the transition points. The fact that a technology is superior than the alternative, think Betamax vs. VHS in the original video format war, is no guarantee that it will be the winner. For the technical-commercial transition, one of the key question that I like to find out is the current product roadmap. The roadmap will provide implicit guide on what kind of technical performance is expected and how a new product will fit into the BU's direction. Another good reality check is if the BU has a history of commercializing new ideas beyond incremental improvements. Adding a feature, however small, is always a shock to the system and you want to make sure that there is a good way to deal with corporate anti-bodies. For the commercial-user transition, I like to understand how users are currently dealing with the problem my solution is supposed to solve. Inertia is a very powerful thing and the fact that you have come up with a better search engine does not mean Google can be dethroned tomorrow.

The toughest type of real-options analysis is when the application(s) is truly novel; therefore, most of the future numbers are best guesses only. For example, although people have developed technique of making CMOS semiconductors on polymer substrate in applications ranging from Organic LED to flexible sensors for a good many years, very few of them have made a meaningful transition to the commercial phase as a part of a product roadmap. In short, this makes it really hard to pass the senior management's "gut check." On the other hand, using the real-options format, you probably have the best chance to convince management to consider on-going investment in this type of project because highlights the option and (minimum) costs to play in an emerging market.

Real-options as a communication tool

Real-options is really about communicating insights in a structured format. An often underestimated benefit of using real-options analysis is that it allows diverse opinions to co-exist. Unlike the traditional NPV (net present value) analysis where everyone is angling for the right discount rate, cash-flow, or terminal value, real-options allows discussants to break down the overall project into logical components so the pessimists can have their say as do optimists. And, as new information is discovered or assumptions confirmed, the tree structure allows the overall integrity of unrelated information be preserved.

A full blown real-options analysis can be a bit overwhelming for the senior team. On the other hand, an appropriately high level reduction is usually a very informative tool for discussion. Conceptually, it should be made intuitively clear that a Yes decision for an investment is really an option to review its progress at the next milestone and any projects will go through several milestones. As long you don't get caught up with the details, real-options is a good way to verbalize/visualize this process.

Finally, what is the appropriate level of reduction for high level management discussion? This is where you want to conduct sensitivity analysis of the structure and hone in on these. Make sure that these assumptions pass basic reality check.