8ACCENTURE JOURNAL OF APPLIED CORPORATE FINANCE

University of Maryland Roundtable on

REAL OPTIONS AND CORPORATE PRACTICECollege Park, Maryland

April 19, 2002

ALEX TRIANTIS, Moderator: Wel-come to this roundtable discussionof real options, which is the final partof today’s symposium. The ques-tions we want to talk about now aresimilar to those that Stewart Myersaddressed earlier this afternoon.Where are we today in terms of thetheory and practice of real options?What is the value added that corpo-rations are getting from using realoptions? What are the success sto-ries we can use to guide us? What arethe remaining barriers to applyingreal options in practice, and how canwe overcome them?

To discuss these questions we havefour distinguished panelists, and let metell you a little about each of them:ADAM BORISON is a Partner (cur-rently on leave) of Strategic DecisionsGroup and Executive Vice President ofXamplify, a startup customer analyticsfirm targeting the financial servicesindustry. He has more than 20 yearsof experience addressing strategicmanagement problems using ad-vanced analytic techniques, and haschaired real option valuation confer-ences and seminars around the globe.He has also led corporate projects inbusiness strategy, M&A transactionvaluation, project investment analy-sis, and enterprise-wide capital allo-cation. Dr. Borison has served on theconsulting faculty at Stanford and the

University of California at Berkeley,and he holds a BS in Biochemistryfrom Yale University, a Masters inPublic Policy from Harvard Univer-sity, and a Ph.D. in Engineering-Economic Systems from Stanford.GILL EAPEN is the Founder and aPrincipal of Decision Options LLC, aboutique consulting firm that special-izes in valuation and portfolio man-agement in technology companies.Prior to establishing the new com-pany, Gill was a Group Director ofFinance at Pfizer, where he was re-sponsible for the financial planningof an R&D portfolio of $4 billion peryear. Previous employers also in-clude Deloitte Consulting, Hewlett-Packard, and Asea Brown Boveri. Heholds an MBA from the University ofChicago, an MS from NorthwesternUniversity, and a BTech from theIndian Institute of Technology.MICHAEL MAUBOUSSIN is a Man-aging Director and Chief U.S. Invest-ment Strategist at Credit Suisse FirstBoston Corporation. He is an ac-knowledged leader in the applica-tion of value-based tools in securityanalysis, and has lectured and pub-lished widely on the subject. He isalso an adjunct Professor of Financeat Columbia’s Graduate School ofBusiness and is the co-author, withAlfred Rappaport, of ExpectationsInvesting, which was published by

Harvard Business School Press lastyear. Michael has been named re-peatedly to the Institutional InvestorAll-America research team and theWall Street Journal All-Star survey inthe food industry category. He alsoserves on the Board of Trustees atthe Santa Fe Institute, a leading cen-ter for multidisciplinary research incomplex systems theory.JOHN McCORMACK is a Senior VicePresident of Stern Stewart, where heruns the firm’s Energy and Utilitypractice. His group establishes EVA-based financial management systemsat major international oil companies,independent producers and refin-ers, natural gas pipeline companies,and electrical utilities. John has 15years of professional experienceworking directly in or primarily withthe energy industries. He startedone of the first energy derivativestrading desks in 1986 at O’Connor &Associates, a private partnershipsince acquired by the Swiss BankCorporation. Just prior to joiningStern Stewart, he was a Vice Presi-dent in the Global Commodity RiskManagement Group of the UnionBank of Switzerland, where he man-aged the bank’s portfolio of energyand metal derivatives. John holds aBA from the University of Pennsyl-vania and an MBA from the HarvardGraduate School of Business.

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9VOLUME 15 NUMBER 2 WINTER 2003

Real Options vs. DecisionAnalysis

I have asked each of the paneliststo provide some introductory re-marks. And I’d like to start withAdam Borison. As I mentioned inmy introduction, Adam has been inthe consulting field for 20 years. Hestarted his career in the practice ofdecision analysis and over time be-came a proponent of real optionsvaluation. So, one of the questionsI’d like to ask you, Adam, is aboutthe confusion that now seems toexist in the corporate world aboutthe differences between decisionanalysis and real options. What isthe value added that we are gettingfrom real options vis-à-vis decisionanalysis? And can you tell us asuccess story where real optionsclearly added value to the decision-making process?BORISON: Let me start by tellingyou about a fairly recent case thatillustrates the benefits of an ap-proach tha t combines thestrengths of real options, which isgrounded in finance theory, anddecision analysis, which comesout of management science. ThenI’ll talk about some of the techni-cal issues in applying the differentmethods.

As Alex mentioned, I spent a num-ber of years consulting in the areasof management science in generaland decision analysis in particular.But since my undergraduate de-gree is in biochemistry and myPh.D. is in nonlinear programming,I never viewed myself as purely adecision analyst. Rather, I evolvedinto a user of decision analysis, justas I later became a user of financetheory, because it seemed to havethe best tools to apply to the prob-lems I was being asked to solve.And this comment ties into someobservations I will make later about

the lack of integration of real op-tions and decision analysis.

So let me give you an example ofa successful project. One of ourclients was a mid-size high-tech com-pany that was worth about $200million on the NASDAQ. Thecompany’s CEO faced a major chal-lenge. Although he was convincedthat the firm’s future value depended

heavily on a robust R&D program,the ups and downs of its businessmade it hard to maintain an appro-priately high level of R&D invest-ment. In periods when earnings andcash turned down, large R&D ex-penditures were hard to defend inquarterly meetings with analysts,who would make statements like“your R&D expenditures are way

Adam Borison

IN MOST OF THE VALUATIONCHALLENGES I RUN ACROSS,THE RIGHT SOLUTION IS TOcombine elements of both real

options and old-fashioneddecision analysis. Real options

can be used to address thoseparts of the problem that

involve so-called “market” or“public” risks. But many

projects also involve “technical”or “private” risks, where

decision analysis is moreapplicable. This decompositionof the problem into private and

market risks is, to me,a necessary condition

for gaining broaderacceptance of real options.

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out of line and it really worries us.”The expenditures were also hard todefend internally, particularly to thefinance people charged with report-ing earnings, raising capital, and man-aging the firm’s ongoing relationswith its investors.

So this CEO felt that it was impor-tant, both to maintain credibility withthe analyst community and for inter-nal planning and control purposes,to understand the appropriate levelof overall investment in R&D and thebest way to prioritize the company’sdifferent R&D projects. We wereable to convince the CEO that deter-mining the right investment leveland priorities was, in some impor-tant respects, a real options kind ofproblem. And he enthusiastically em-barked on a set of projects with us tofind the answers.

We took four of the company’smajor R&D investments, all in vari-ous areas of semiconductor manu-facturing technology—one tied inwith traditional chip manufacturing,another in advanced chip manufac-turing, another in fiber optics, andanother in micromachines—and weused real option valuation to evalu-ate the expected payoffs and majorrisks associated with each. We lookedat the individual projects in a waythat, consistent with real options,combined valuation and strategy.That is to say, the value of theprojects depended on both the ex-istence of real options—typically theright to structure the projects instages, and then abandon or expandthem depending on future develop-ments—and the assumption thatmanagement would exercise thoseoptions at the right time. The funda-mental management questions weaddressed were these: If you havelimited resources and you make allthese investments at once, how muchvalue do they add individually? Andwhich investments add the most

value, and should the company re-ally be focusing on them? Providinganswers to these questions was thegoal of the project.

This approach was very success-ful in that it captured the CEO’ssense of the major management is-sues and sources of uncertainty,added formal structure and analysisthat greatly raised the level of debate,and produced results that both madeintuitive sense and stood up to inten-sive examination. We did not go intogreat depth with our client on thesubject of analytical tools, aboutwhether we were using Black-Scholes,risk-neutral probabilities, or binomialtrees. We used mainly what I call “risk-adjusted” decision trees, which are avery effective tool for giving manag-ers a qualitative understanding of thekey issues and concepts as well as ameans of quantifying the expectedeffect of alternative investment strat-egies. Someone trained in financetheory would probably say that weended up with more of a decisionanalysis than a real options approach,with a lot of detail on uncertainty andflexibility, and with a great deal ofattention paid to the internal manage-ment view of value. But this wasclearly the kind of analysis that theCEO wanted, at least initially.

The ultimate aim of the project,however, was to give the client a wayof measuring the contribution of theR&D projects to the company’s ex-ternal or market value—that is, a wayof measuring the incremental valueof the projects to the value of aportfolio held by well-diversifiedinvestors.

When we started working withthis client, the stock price was $10,and today it is $20—though it did gothrough $40 on the way—and thishas been during a period when thestock prices of most major high-techcompanies have declined. A majorcontributor to the company’s recent

success is the R&D project that weidentified as the top priority andwere able to value for them. Theclient firmly believes that the optionvalue of this project alone is con-tributing significantly to the firm’smarket value. The value is clearlynot coming from current cash flowsor optimism about the high-techindustry.

This case illustrates how to un-derstand, evaluate, and prioritizeR&D projects by viewing them asreal options—valuable sources ofcorporate flexibility that, if properlymanaged, can be used to createeven more value. We created a toolthat enabled a CEO to take theinvestors’ point of view, and, fromthat vantage point, he was able tomake decisions about which projectsto pursue and which to table, giventheir available resources. Real op-tion valuation helped this companymake decisions that ended up add-ing value. The company is nowusing this approach internally, with-out any assistance from us. Its peopleare off and running, applying theseideas on their own.

To return to your question, Alex,was this truly a “real options” project?I think so—but to explain this I willhave to go a little into some techni-cal issues. In my view, there aresome important differences betweendecision theory and finance theorythat are not widely appreciated.The practice that I ran earlier in mycareer was called “real option valu-ation,” or ROV. That practice in-volved the union or, more precisely,the integration of these two disci-plines. In my view, real options anddecision analysis are not so muchcompeting techniques as two im-portant complementary elementsin the overall approach.

In his talk earlier this afternoon,Stew Myers said that he was seeingsigns of convergence, or growing

11VOLUME 15 NUMBER 2 WINTER 2003

agreement, between the people indecision analysis and those in “clas-sic” real options. While I agree inpart, I think there is still a consider-able way to go. A lot of the resistanceto implementing real options to-day—and it’s a major source of frus-tration to me—is the cacophony ofvoices about when real options is anappropriate valuation technique andwhen other approaches are moreapplicable. People are asking a lot ofimportant questions: Do we reallyneed a replicating portfolio? Is Black-Scholes appropriate to use? What isthis decision tree vs. that binomialtree? The confusion about thesetechnical issues is due in large part tothe fact that the management sci-ence and finance communities stillaren’t close enough together—andthis confusion is getting in the way ofcorporate adoption of real optionstechniques.

There is a historical reason formuch of this. Decision analysis pur-ists learned their craft by focusing ondecision-making by individuals in-tent on maximizing utility, and not ondecision-making from the point ofview of diversified shareholders aim-ing to maximize value. For many ofus, our first encounter with decisionanalysis involved the so-called partyproblem: whether to hold a partyinside, outside, or on the porch,given the possibility of rain. This typeof problem of individual decision-making under uncertainty, while im-portant, is of limited relevance to afirm that is supposed to be acting tomaximize the wealth of its investors.But there are similar problems on theclassic real options side. A methodoriginally built on the foundation ofreplicating portfolios, arbitrage, andgeometric Brownian motion clearlyhas its limitations, too. So, I would saythat communication between thosetwo worlds—that of pure finance andpure decision theory—needs to be

improved so that the two fields cancome together.

In sum, I believe that the approachthat succeeds in uniting the best ofthese two disciplines, which is whatI mean by the term real options, isvery powerful, and will ultimately besuccessful in the corporate world.Progress is going to be a little slowuntil the two disciplines iron outtheir differences and recognize howpowerful they can be by joiningforces; but I’m generally optimistic.

Real Options and CorporatePerformance Measurement

TRIANTIS: Thanks, Adam. We’ll turnnext to John McCormack. As I men-tioned earlier, John works for SternStewart & Co. Stern Stewart is wellknown for getting companies to fo-cus on economic value added, orEVA, rather than reported earnings,and for setting up incentive com-pensation systems based on EVA.Maximizing a company’s real optionsvalue can be quite different frommaximizing its current earnings pershare; and that difference is in factone of the major barriers to thecorporate use of real options at themoment. John, I’m hoping you willshow us how we can build a realoptions perspective into existing cor-porate performance measurement andincentive systems so as to overcomethis barrier. In particular, how do wemotivate managers to exercise theirreal options at the optimal time—forexample, to avoid producing oil whenprices are too low—and so maximizethe value of their options?McCORMACK: I promise to addressthe performance measurement andincentives issues in a moment. But letme start by answering a question youasked earlier: Where are we now inthe practice of real options? I charac-terize it as somewhere between earlychildhood and adolescence. The suc-

cess stories we can boast of wouldnot surprise anyone who heard StewMyers’s keynote address earlier to-day. Those are the cases where thereis a lot of structure to the problem,where the underlying asset can bemodeled, and where there is notmuch interaction with competitors.

One of the areas of success that Ican at least mention, even if I can’tdescribe it in much detail for confi-dentiality reasons, is the oil and gassector—and, more specifically, theexploration and development part ofthat sector. It shouldn’t come as asurprise that people in explorationare receptive to real options, if onlybecause so many of those peoplehave a background in decision analy-sis, or in areas associated with DA. Butlet me also say that, for those peoplewho are generally familiar with deci-sion analysis, it is a hard sell to getthem to believe that an RO approachis significantly better.

Where we are having some suc-cess, however, is in applying a familyof option models to the problem ofdeciding when to develop provenreserves. And I can think of at leasttwo good reasons for this. First, op-tions to develop existing reservesrepresent a clearer and more trac-table valuation problem than optionsto explore for reserves, where thereare many more key variables to takeaccount of. Perhaps also important,the engineers in charge of develop-ment projects are likely to be morereceptive to real options than thegeophysicists in charge of explora-tion because, unlike the geophysi-cists, the engineers generally haven’tbeen trained in decision analysis.They represent a blank slate; they’restarting from scratch, and we have atool to help them.

The second area in which we havedone a fair amount of work is in peak-ing capacity and electric power gen-eration. There are some very tricky

12JOURNAL OF APPLIED CORPORATE FINANCE

issues here. The first is the fact thatthe distribution of power prices isdefinitely not lognormal; and thesame holds for the so-called “sparkspread,” which is the difference be-tween the cost of the natural gasinput and the price of the electricpower output. In fact, the distribu-tions of these two variables aren’teven lognormal over long periods oftime. Also complicating attempts touse real options is the fact that whatone power producer decides to dowith one of its peaking units canhave a dramatic effect on the eco-nomics of the other producers; sothere are some sticky portfolio is-sues arising from these competitiveinteractions. And I can’t say that wehave any elegant solutions to thoseproblems at the level of RO modeling.

But even if there is a lack ofprecision in the valuations providedby RO models, we can use the gen-eral approach to make importantcorporate decisions, such as how toallocate decision-making authoritywithin corporations and the optimaltime horizon for performance mea-surement and incentive compensa-tion. To give one example, you cancombine a real options approachwith Stern Stewart’s “bonus bank”incentive compensation concept toensure that the cumulative compen-sation of a group of managers corre-sponds to the performance of a port-folio of assets over, say, a three- tofive-year time period.

So, in general, the prospects for realoptions applications in the energy andpower businesses look very bright.The pharmaceutical area, however,is a different story—one that I’m justnot that familiar with. We’ve hadpharmaceutical clients, but they’veused standard decision analysisrather than real options in managingtheir R&D portfolios. But there isone potential real options applica-tion outside of energy that I am

particularly excited about right now,and that is real estate. Retailers havehuge real estate exposures, and themanagers who have at least an intui-tive understanding of real option pos-sibilities have built all sorts of cancel-lation rights and other elements ofcontractual flexibility into their rela-tionships with landlords. Based onwhat I’m seeing, these sources offlexibility provide option value thatcan add up to several dollars per shareto a retailer’s stock price. It can be asignificant source of value.

So, what have we at Stern Stewartlearned from our first attempts toapply real options inside companies?The first thing I would say is thatperhaps the most important distinc-tion between the Black-Scholes worldof financial options and the corporateworld of real options is the link be-tween real option value and the com-petence and motivation of the peoplemanaging the real options. The valueof a financial option is basically thesame no matter which institution ownsit. But that statement is definitely nottrue for real options. In fact, exploit-ing real option value has everythingto do with a company’s managerialand operational competence.

For example, if your ability to ex-tract real option value from undevel-oped oil and gas reserves depends oncompleting the well several times fasterthan your competitors, then you haveto be able to operate well within thetraditional one-year budget plans usedby most companies. But that kind ofcapability will require giving muchmore decision-making authority to mid-level managers. The problem, how-ever, is that allowing their operatingmanagers to deviate sharply frommarching orders issued six months agowould be a transforming event formost oil companies of any size.

So, changing the allocation of deci-sion rights within companies, I wouldargue, is an essential first step toward

enabling managers to maximize thevalue of their real options. For ex-ample, there are a lot of financiallyoriented energy companies that as-sign all of the decision-making au-thority for taking peaking powerplants up or down to traders on thetrading desk. But I think that’s amistake. The traders may know a lotmore math and options theory thanthe operating managers, but theoperating managers are the peoplewho understand how quickly, andhow often, you can start and stopthese operations. Now, you mightargue that managers at the plant levelmight prefer a more predictable rou-tine (and bonus), and so prefer not toparticipate in these decisions. But ifthe operating managers share in acommon bonus pool with the peopleon a trading desk who trade sparkspread options, then all of a suddenyou have the basis for a kind ofcooperation between these two verydifferent groups that you never hadbefore. And I think decisions thatcombine financial and operating ex-pertise will be much more soundthan those made from a financialperspective alone.

Finally, some points about incen-tive compensation. We don’t haveany really elegant solutions here,but I think it is a mistake to try to havetoo small a group of bonus partici-pants. There is a theory that says it’sbest to design incentives for verysmall business units or particularindividuals in order to minimize free-rider problems. Now, I agree thatcompanies may in fact want to mea-sure and keep track of results at thatlevel for information purposes. Butif you’re going to compensate peoplein a large organization in a way thatencourages both the creation andoptimal management of real options,my own experience suggests thatyou need a large enough aggrega-tion of projects with real options

13VOLUME 15 NUMBER 2 WINTER 2003

embedded in them, and enough yearsin the plan that the law of largenumbers can operate. This is wherethe value of the multiyear bonusbank that I mentioned earlier be-comes apparent. This way, if you getan aberration in one year, then thateffect is neutralized by averaging itover a three- to five-year period.

In this regard, the financial risk man-agement decisions and the incentivedecisions of most corporations are in-tertwined. For example, depending onhow you set up the target bonus poolfor a peaking power plant, you maywind up driving the managers of thatoperation to hedge all or none of thespark spreads from a given unit.They may decide that even if theyhave only what amounts to a bunchof out-of-the-money options on thespark spread, what they should reallydo is call up Dynegy and say, “Giveme a bid on all of these out-of-the-money options that we’re holding,and we’ll just go back to our job andwait for that telephone call when youdecide to exercise those options.”

Now, all this may not sound likeactive management—or somethingthat managers ought to be paid for.But, in many cases, it will be the value-maximizing strategy for the firm. Thatis, having created the option by build-ing the peaking plant, the managers ofthat plant should be rewarded foreliminating risks and then sitting tightuntil the options come into the money.And I don’t have to tell you that this isa hard lesson for many managers tolearn—that value can be created sim-ply by waiting, doing nothing.

I will close by making one otherpoint about the practice of setting upincentive targets. Twenty-five yearsago, Stew Myers made a distinctionbetween the two primary compo-nents of a company’s value: assets inplace and growth options. At SternStewart, we refer to those two com-ponents as “current operations value,”

or COV—what a company would beworth on an NPV basis if its currentlevel of EVA were expected to con-tinue forever—and its “future growthvalue,” or FGV, which is simply thedifference between a company’s COVand its current market value. Mostcompanies, even after the recent sell-off in the stock market, trade for a lotmore than their COV. And, as you

might expect, for many companiesthe FGV number is an options-richcomponent of value. From that FGVpiece of a company’s total value, it ispossible to make some intelligentestimates of what the market ex-pects the company’s annual level ofgrowth to be. And those estimatescan in turn provide a basis for settingup “market-driven” incentive targets.

THE MOST IMPORTANTDISTINCTION BETWEEN THEBLACK-SCHOLES WORLD OFfinancial options and thecorporate world of real optionsis the link between real optionvalue and the competenceand motivation of the peoplemanaging the real options.The value of a financial optionis basically the same no matterwhich institution owns it.But that statement is definitelynot true for real options.In fact, exploiting real optionvalue has everything to dowith a company’s managerialand operational competence.For example, if your ability toextract real option value fromundeveloped oil and gasreserves depends on completingthe well several times fasterthan your competitors, thenyou have to be able to operatewell within the traditionalone-year budget plans usedby most companies.

John McCormack

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Real Options in thePharmaceutical Industry

TRIANTIS: Thanks, John. Now let’sturn to Gill Eapen. Gill, you worked inthe pharmaceutical industry for a num-ber of years. And this morning we sawa couple of different versions of a fairlycomplex model to solve a real optionsproblem in the pharmaceutical indus-try. It looks like a pretty complicatedundertaking. Developing the model isdifficult, estimating the inputs is chal-lenging, and managing the project inthe way in which the model says youshould requires careful monitoring. Ingiving us your assessment of wherewe are now in terms of the practice ofreal options, I hope you will touch onsome of these issues of complexity. Atwhat level is real options analysis be-ing implemented at the current time?Should we expect that, in five or tenyears, rigorous real options modelssuch as those we saw this morning willbecome more commonplace in thepharmaceutical industry?EAPEN: Before I answer those ques-tions, let me start by saying that I ama relative newcomer to the field ofreal options. My interest startedabout five or six years ago, when Iwas responsible for the financialmanagement of an R&D portfolio atPfizer and Professor Myers came totalk to us about real options. At thetime, we were looking at what arecalled “discovery technologies,”early-stage technologies just com-ing into the pipeline that are tenyears or so away from market. Wewere talking to four different compa-nies about buying or licensing thesetechnologies—in fact, a whole rangeof different kinds of arrangementsand contracts were being consid-ered. And we were sitting aroundthe table and asking the question,“How much should we pay for thesetechnologies and the rights the vari-ous contracts would give us?”

At the time, we were still basingour analysis on the use of standarddiscounted cash flow and NPV. Butit seemed clear to us that the invest-ments we were contemplating had“platform-type” technology character-istics in the sense that we were likelyto be able to build on them in thefuture—and which gave them realoptions value. We thought of theseinvestments as playing a role at Pfizerthat a new aircraft or automobileplatform design would play for acompany like Boeing or GM.

So, we started thinking about realoptions. But when we got into a lot ofpartial differential equations and finitedifference solutions, the project startedto meet with some resistance. Even so,the general feeling within the com-pany was that the intuition behind thisanalysis made sense. We knew that theNPV of each of these individual invest-ments would be negative if we werebeing at all realistic in our cash flowforecasts because of the low prob-ability that any one of them wouldend up coming onstream. But wewere also convinced that these in-vestments had value for the com-pany. So, this was a case where man-agement felt that the standard DCFsystem was not working; and thoughthey didn’t know anything about realoptions, they were willing to listen tosomething new and think about it.

And I think that, in the last fiveyears, pharmaceutical companieshave come a long way in this respect.To give you a recent example, weare now working with a large phar-maceutical company that is lookingat a therapeutic area within the com-pany. The research being done inthis part of the firm is very differentfrom the company’s other, moreconventional products in terms ofthe discovery process. The FDA hasnever approved any of these prod-ucts in the past as there have beena lot of technical questions.

Because this operation is so differ-ent, management was looking for someway to segregate it from the rest of thecompany. One idea was to create afully owned subsidiary, and anotherwas to carve out a stand-alone privatecompany. The eventual solution, how-ever, was to spin off this franchisecomprising six different products into aseparate, publicly traded company.

In preparing for this step, the firstquestion we addressed in our analy-sis was: What is this franchise worth?Since the six products were all in earlyPhase I or Phase II stages, we couldn’tdemonstrate that they had any sort ofvalue from an NPV perspective; infact, they all appeared to have anegative NPV. So, this was a situationwhere we could actually do real op-tions analysis, and estimate the valueof these products. On the basis of ouranalysis, we then designed a contractthat would give the pharmaceuticalcompany the option to buy theseproducts back if they completedPhase III or registered a patent. Thecontract could include milestone pay-ments or R&D payments and so on.

To summarize the transaction,then, the pharmaceutical companyturns over its six products in thetherapeutic area to NewCo, andNewCo grants an option to the phar-maceutical company, which is essen-tially an option on the R&D pipelineof NewCo for a period of, say, fiveyears. Using our valuation, the trans-action was structured to make thecurrent value of the option exactlyequal to the value of the franchisebeing spun off, so that it is a neutraltransaction for the pharmaceuticalcompany. And the valuation we pro-vided is now being used to raise theexternal financing needed to estab-lish NewCo.

So, I’m very hopeful about realoptions applications, particularly inthe pharmaceutical and biotechnol-ogy areas. People in those sectors

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have been very willing to listen tonew ideas, and this is an environmentwhere it is very clear that the conven-tional techniques may not be thatuseful. So, when we come to seecompanies in these sectors, they arealready looking for a better way.

But let’s go back to Alex’s ques-tion about complexity, and how wecan simplify this technique. I thinkthat Professor Myers was exactly righttoday. My belief is that we may havebeen complicating things more thanis necessary. There are two questionsthat we are invariably asked when westart talking about real options to acorporate manager. One is whetherall the assumptions required to jus-tify the use of real options are reallyrelevant or necessary; and the sec-ond is what type of complex math isin our black box. The answer to thefirst question, as Stew told us earliertoday, is that the assumptions youmake when using real options areessentially the same as those youmake when using the CAPM anddiscounted cash flow techniques. Inmy experience, most senior manag-ers don’t really know the assump-tions that underlie the use of CAPM—nor do they particularly care. Theyknow that there are potentially valu-able investment projects out there;and they know that the expectedcash flows from those projects arerisky and that money receivedsooner is more valuable than moneyreceived later. They also feel that theCAPM does a reasonably good jobof capturing both of these realities.

So, in order for us to be successfulin expanding the use of real options,I don’t think it’s necessary, or pro-ductive, to get into long discussionsabout the assumptions underlyingthe model. Although there are ex-ceptions to this, corporate managersin general do not tend to care whethera model assumes that futures pricesare mean-reverting or move accord-

ing to geometric Brownian motion.What they care about is whether themodel captures their intuitive senseof the major risks and opportunitiesconfronting the business, and theeffects of these risks and opportuni-ties on value.

And, as Professor Myers also saidearlier, good managers have alwaysmade decisions by taking account of

the flexibility built into projects; thereis nothing new here. If you’re amanager making a $100 million in-vestment decision with a ten-yearpayoff and multiple decision pointsalong the way, you’re not going tocommit to spending the entire $100million today. You’re going to ex-periment for the first year to getmore information before taking the

AS PROFESSOR MYERSTOLD US EARLIER, GOOD

MANAGERS HAVE ALWAYSmade decisions by taking

account of the flexibility builtinto projects; there is nothing

new here. If you’re a managermaking a $100 million

investment decision witha ten-year payoff and multipledecision points along the way,you’re not going to commit to

spending the entire $100million today. You’re going toexperiment for the first year to

get more information beforetaking the next major step.

In this way, real options playsdirectly to managers’ intuition

about where much ofthe value comes from.

Gill Eapen

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next major step. So, in this way, realoptions plays directly to managers’intuition about where much of thevalue comes from.

That said, I do think we have towork harder to recast the results ofreal options analysis into simplerlanguage, and so build some trustwith managers inclined to dismiss itas another black box. As academicsand consultants, we need to con-tinually check the mathematics ofthe models against managers’ intu-ition. Managers have to feel comfort-able before they’re willing to takethe leap to a new method; and ithelps for them to see that althoughreal options is a new language, theunderlying concept is nothing new.It’s just an attempt to give form andrigor to a process that managers, atleast in the R&D area, have beenusing for decades.

What real options has succeededin providing, as Stew Myers was alsothe first to point out, is a means oflinking corporate finance and strat-egy—two disciplines that, until re-cently, were drifting farther apart ascorporations were forced to adaptmore quickly to changes in technol-ogy and the competitive environ-ment. I attended a number of meet-ings at major corporations where wesaid, “We’ve done our financial analy-sis; and although the NPV is nega-tive, we think this decision makessense and we’re moving forwardwith it anyway.” So, despite all thetime and effort that went into it, thefinancial analysis ended up beingirrelevant to the final decision. Butreal options has given finance pro-fessionals a way to become relevantin strategic decision-making.

One thing that is likely to help theimplementation of real options issoftware. We have developed agraphical tool that allows a managerto formulate a problem using a deci-sion tree framework, and then to

quantify the real option value usingMonte Carlo simulation. But if wenow have the valuation techniquesand the software necessary to applythose techniques, there is still a big-ger challenge facing us: finding a wayto communicate the resulting valua-tions to Wall Street.

Wall Street’s Take on RealOptions

TRIANTIS: Thanks very much, Gill.Your comment about Wall Streetgives me a nice lead-in to our nextpanelist, Michael Mauboussin. As Imentioned, Michael is a highly re-garded investment strategist at CreditSuisse First Boston, as well as some-one who has written extensivelyabout real options. A lot of what wehear about real options in practice isabout how corporations are using itto improve their decision-makingprocesses. So, there is a lot of curios-ity in terms of whether Wall Street isusing “real options.” And if analystsand portfolio managers are usingreal options, how are they using it—to assess the value of different cor-porate strategies, or to value entirecompanies?

This last question is particularly im-portant because corporate practitio-ners feel the need to respond morecoherently to Wall Street’s questionsabout their investment strategies, theirstrategic plans. One of the first thingsmanagers look at when evaluatingan investment decision is its expectedeffect on EPS, because that is whatthey will have to talk to analystsabout. And for this reason alone,many people believe that there is thepotential for a strong pull from WallStreet in terms of the use of these realoption techniques, and I’d appreci-ate it if you could talk about whetherthat pull is likely to materialize soon.MAUBOUSSIN: Thanks, Alex. In re-sponding to your questions, I’d like to

talk about three things. First, I’d like totell you a little about how we are usingreal options in the investment processat CSFB. We’ve been doing this forthe last three or four years. In fact, Icould probably trace the genesis ofthe use of real options at CSFB to aphone call I received about five yearsago from our cable analyst. She said,“I’ve got a bit of a tricky situation here.My cable companies are upgradingtheir cable plants to 750 MHz; they’reusing 650 MHz now, so there’s 100MHz of dark fiber. Some smart 25 yearold is going to figure out a coolapplication for this dark fiber downthe road, and it’s going to be a sourceof value. How do I think about this?”

So, I started talking to her about realoptions in a very general sense, andthen put her in touch with experts whocould talk about it in a much morespecific way. It was in the context ofthis cable company application thatour cable analyst and I first went outand talked about real options to theinvestment community—and it wasgenerally well received. We also usedreal options in talking about value instartup companies and Internet busi-nesses like Amazon.com—and I has-ten to add that we carefully avoidedsaying that real options justified thelevel of stock prices that these compa-nies reached. We have also been con-tacted by a number of companies thatwant to know, first of all, whether theyhave significant option value; and, if so,how they should go about communi-cating that value to the market.

The second factor I want to ad-dress is how we approach this froman investment standpoint. From acompany’s perspective, these arefundamental corporate finance is-sues; the use of real options is abouthow to allocate capital and how tomaximize shareholder value. Inves-tors are also allocators of capital; butthey are doing something differ-ent—they are seeking to identify

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mispriced securities. There’s an oldrule that if you think a stock is fairlyvalued, you don’t invest. What youare really trying to do is to findsituations where there is a reason-able margin of safety, and where youbecome convinced that the markethas a set of expectations that areinappropriate at the time and thatsomehow will be revised.

As described in the book Alexmentioned that Al Rappaport and Irecently wrote, we at CFSB follow apractice called “expectations invest-ing” that essentially works backwardfrom the current stock price. Westart with the current price and thenattempt to infer from that price in-vestors’ expectations about futureearnings and cash flow. And if wethink the expectations reflected inthe current price are too low, thenwe invest.

Now, how do real options comeinto the picture? We go about thisanalysis in a couple of steps. The firstis to try to understand whether ornot a company has the potential forsubstantial real options value. That ispretty much a qualitative judgment,and it has three main components.The first thing we want to know iswhether there are major sources ofuncertainty in the business, becauseif uncertainty levels are low, then theoption value will probably not bematerial. The second consider-ation—which is something that JohnMcCormack emphasized and I agreewith completely—is the quality ofmanagement. Having a managementteam that knows how to identify,create, and then exercise real op-tions is critical to corporate success.I have seen quite a number of caseswhere companies had valuable realoptions but failed to exploit themintelligently. One example is Xerox,which developed several promisingtechnologies for PC’s but failed tocapitalize on them.

The third thing we consider whenassessing possible option value is acompany’s market position. As ageneral rule, companies with stron-ger market positions often find them-selves with more options, or at leastin a better position to exploit them.

Having considered these threefactors—uncertainty, quality of man-agement, and market position—we

then attempt to estimate what we callimputed real option value. Our wayof doing this follows the Brealey-Myers thought process. We start byvaluing the assets-in-place—the busi-nesses we can touch and feel todaythat are generating the current earn-ings and cash flows—and we useDCF to value those businesses. If thatvalue is something vastly different

IN TRYING TO UNDERSTANDWHETHER OR NOT ACOMPANY HAS THEpotential for substantial realoptions value, the first thing wewant to know is whether thereare major sources ofuncertainty in the business.The second consideration is thequality of management.Having a management teamthat knows how to identify,create, and then exercise realoptions is critical to corporatesuccess. The third thing weconsider is a company’s marketposition. Companies withstronger market positions oftenfind themselves with moreoptions, or at least in a betterposition to exploit them.

Michael Mauboussin

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from the stock price, then there aretwo main possible explanations. Thecompany may simply be overval-ued—or it may have considerablereal option value.

To decide which of these twoexplanations accounts for this ap-parent growth value, we then dosome reverse engineering. One partof this process, you might be inter-ested to know, was inspired by a tablethat appears in the fifth edition ofBrealey and Myers (though not in thesixth for some reason). The point ofthe table is to show how option valuechanges both with the ratio of projectvalue to investment needs—the ratioof “S to X” in the table—and withdifferent estimates of volatility. Op-tion pricing theory suggests that suchvalue tends to be strongly positivelycorrelated with volatility—and thetables themselves provide a usefulway of providing some quantitativegrounding for the intuition that therecan be considerable value in projectswith highly uncertain outcomes.

So, at the end of the day, if weconclude that the option potential islow, and the stock is trading wellabove its current DCF value, then thecompany is a sell. If the option poten-tial is low, and the stock is tradingessentially on the basis of currentcash flows, then the company is as-sumed to be fairly valued on a DCFbasis. But if the option potential ap-pears to be high, and the stock isn’ttrading much above its DCF value,then that’s a buy—you’re getting theoption value for free. The tricky casesare those where the option potentialis high, and the stock is trading wellabove its DCF value. Those are thecases where you really need to beable to analyze the growth potentialand the value of the real options thatare already reflected, at least to someextent, in the company’s price.

So, to summarize, we come upwith a real option value that appears

to be reflected in the current stockprice, and then we ask ourselves,“What has to happen for that optionvaluation to make sense? What kindof market opportunities are there,and what are the major sources ofuncertainty that will determinewhether those opportunities materi-alize?” And this kind of reverse engi-neering, as I said earlier, is part of ourinvesting strategy at CFSB.

The third and final question I wantto take up is the extent to which WallStreet is embracing the concept andlanguage of real options. When youtalk about Wall Street, it’s importantto be clear about whether you’retalking about the “sell side”—theinvestment banks and brokers whoseincentives are to sell stocks andtransactions—or the “buy side,” thepeople who are actually buying stocksfor investment portfolios. Now, letme start by saying that I agree withProfessor Myers’s statement that realoptions is “central” to the practice ofcorporate finance. When you talkwith top executives, you find outthat the idea, or the concept, of realoptions are important to them. AndI think the same thing can be saidabout investors, particularly buy-side investors. They too think thatreal options are going to be a majorsource of future growth for manycompanies. They may not call them“real options,” or have the faintestidea how to quantify their value.But they clearly understand that thesources of flexibility and corporatecapabilities that some people callreal options are major contributorsto a company’s current value.

And let me give you one quickexample to illustrate my point. In theclass I teach at Columbia University,I recently brought in a very promi-nent mutual fund manager, a manwho outperformed the marketeleven years in a row. He discussedhis analysis of a company called USA

Networks, which is run by BarryDiller and has a lot of promisingfuture growth businesses as well assome current cash generators. Andwhen we asked the portfolio man-ager why he owns the stock, he said,“When we value the current, cash-producing businesses of USA Net-works, we get a value exactly wherethe stock is today. So our feeling isthat we’re getting all the option valuecreated by Barry Diller—all thosebusinesses he is now developingand all the businesses he has yet todiscover—essentially for free.” Now,there is nothing precise or quantita-tive about this kind of investmentanalysis. But this portfolio managerclearly understands that the kinds ofbusinesses that Barry Diller is run-ning are potentially laden with op-tions—and that Diller himself repre-sents a kind of option. As JohnMcCormack said earlier, a lot of thevalue of real options comes down tomanagement, and whether or notthey are capable of recognizing andexploiting the value of these options.

Abuses of Real Options?

TRIANTIS: Thanks, Michael. I’d liketo ask a few follow-up questionsbased on the comments that weremade. Some people claim that thetheory of real options contributed tothe Internet bubble. Also, becauseEnron became a kind of poster childfor real options, some have evenwondered if real options played arole in the collapse of that company.To what extent do you think that thebursting of the New-Economybubble has affected people’s per-ceptions of real options on WallStreet and in corporations?MAUBOUSSIN: There was a sense inwhich real options provided thebest explanation for why companieswithout earnings could have posi-tive values—and in fact enough value

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to be taken public. But few analystsI know were using real options tojustify the prices we saw at the heightof the Internet and NASDAQ bubbles.As I said earlier, there are threequalitative characteristics—major un-certainties, talented managers, andstrong market position—that we useto identify companies that are likelyto have significant option value. AndI think the companies that fall intothis category—companies likeAmazon.com, eBay, and Microsoft—have proven to be less overvaluedthan other firms without those fea-tures. In that sense, a sound realoptions analysis might actually haveprevented investors from falling preyto the general enthusiasm.

As for Enron, I spent a fair bit of timewith the company’s management in1999 talking about real options. Andthough they were keen on some ofthe ideas, I think the problems withEnron turned out to be much morefundamental than their application ofreal options. Their businesses wereearning well below their cost of capi-tal and they were growing at a break-neck pace, and those two things arenot a good combination.McCORMACK: I agree with Mike.The critics of real options who citeEnron are reversing cause and ef-fect. It’s true that some Enron enthu-siasts talked about their applicationsof real options, for example in theirinnovative use of “peaker” powerplants. But the use of real optionshad almost nothing to do with thecompany’s downfall. The real cul-prit, in my view, is what we at SternStewart call the “accounting model”of stock market valuation that Enron’smanagement embraced. The ac-counting model, in brief, says that thevalue of a company is its currentearnings per share multiplied by astandard, industry-wide P/E ratio. Andif you subscribe to that idea, as Enron’smanagement did, then the goal is

clearly to maximize EPS, regardless ofthe means or the consequences.

The maximization of real options,however, has at most a very indirectconnection with EPS. In fact, in manycases, a company intent on maximiz-ing its real option value will takesteps—like not developing oil re-serves when prices are low—thatend up reducing its near-term EPS.

BORISON: Based on my own mod-est contact with Enron, my under-standing is that option pricing andeven real options were used atthe operations level and on thetrading floor, but RO was rarely ifever applied at a strategic level.More generally, most big or not-so-big oil and gas companies nowview real options as a key part of

Alex Triantis

THE BLACK-SCHOLES MODELALLOWED MORE COMPLEXDERIVATIVES TO BEdeveloped, and allowed optionsand other derivatives to betraded in a more liquid way.Valuation based on realoptions may end up having asimilar effect, perhaps to thepoint where some forms of realoptions actually trade ascontracts in secondarymarkets. For instance, optionson capacity in thesemiconductor industry thatare now built into agreementsbetween companies maysomeday be traded inliquid markets.

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the way they evaluate their strate-gic exploration and developmentinvestments. Real options has alsohad significant penetration in thepower industry. And I think thatthis trend will only increase withtime. So, I haven’t seen much push-back against real options from theEnron collapse.EAPEN: Far from the cause of Enron’sproblems, I think that a real optionsapproach, if taken by top manage-ment as well as on the trading floor,might actually have prevented theproblems at Enron. My feeling isthat there is no substitute for goodintuition about what creates valueover the longer term. And if allcompanies were run by smart man-agers with good intuition, then theremight be no fundamental corporateneed for real option methods. Theproblem, however, is that intuitionis not always reliable, and it’s valu-able to have a more rigorous pro-cess for framing and quantifyingthat intuition. And I would say thatit’s especially important to havesuch a process in environmentswhere you’re not likely to know thepayoff from an investment for thenext ten years, where the peoplemost directly responsible for thedecision move on to other jobs, andwhere there are thus no account-ability and incentive feedbackmechanisms. The greater objectiv-ity of the real options approach,although certainly not foolproof,may provide a safeguard againstsome of the problems that can arisein these situations.

And in response to Alex’s firstquestion about the Internet bubble,I think the broader application of areal options framework by investorsmight actually have limited the sizeof the bubble by introducing somefundamental analysis into a valua-tion process that seemed to have leftall fundamentals behind.

Real Options, Quality Control,and Performance Evaluation

TRIANTIS: If I could continue to playdevil’s advocate, I’ve often heard thecomment that real options is so muchmore complicated than DCF. If weconsider that there are many basicways to abuse DCF in practice, won’tthe potential for abuse be even greaterwith a more complex tool like realoptions? What are the ways in whichquality control can be ensured whenusing real options analysis?EAPEN: Let me try to illustrate myanswer with a real case. We workedwith an investment bank in Europethat was attempting to value an ap-plied technology company. The com-pany had six products in its pipeline,and the investment bank had usedDCF to value the entire portfolio ofproducts. But, in arriving at their an-swer, they had ignored a fundamentalpart of the problem: they did not takeinto account the fact that the probabil-ity of success of each of the productswas less than 100%. So, what they haddone in effect was to assume that all sixproducts would eventually come tomarket and that the price would be somany euros for each.

In this case, it was our own ground-ing in real options analysis that causedus to look for the probabilities ofsuccess of the various products in theanalysis. And in this sense, the morerealistic treatment of uncertainty inthe real options approach can enableus to correct some basic mistakes inthe DCF analysis, because DCF effec-tively buries all uncertainty by ac-counting for it with adjustments tothe discount rate. So, I think that theperspective afforded by real optionsanalysis might actually help us toimprove DCF valuation, a point thatStew Myers made earlier.McCORMACK: My feeling is that themost reliable way to ensure soundinvestment decision-making is to

have a financial management systemthat keeps a record of the profitabil-ity of all major investments. Youcould use something as crude as acompany’s weighted average cost ofcapital—and let’s say it’s 10%—tosee whether $1 invested today isworth $1.10 a year from now, $1.21two years from now, and so forth.And though there will always besome difficulty in marking the in-vestments to market each year, thatsimple kind of system would actuallybe good enough for most compa-nies. Moreover, the same systemcould also be used to evaluate theprofitability of past acquisitions. Ineither case, it’s important to keeptrack of the amount of cash (orstock) used in making an acquisitionor carrying out a business plan or aproject and the return realized overtime from such investments.

If a company institutes and thensticks to this process over a multi-year period, it will gain very usefulinformation about the payoff, interms of shareholder value, of itsinvestment process. And, to comeback to Alex’s question, this kind offinancial management system is likelyto be the best way to ensure that yourreal options analysis is reasonablyconsistent with economic reality.TRIANTIS: That brings up an inter-esting point as to what businessprocesses need to be in place for realoptions analysis to be successful ina corporation.McCORMACK: Gill mentioned that alot of senior executives don’t under-stand the assumptions that underliethe use of CAPM. But the problem goeswell beyond that. Many executiveshave little understanding of what isnecessary to create long-term value fortheir stockholders. Take the case ofBernie Ebbers of WorldCom. I used tothink he was brilliant until I heard himexplain in a public forum why it wasreally important to have acquisitions

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created under the pooling-of-inter-est accounting method rather thanthe purchase method. These account-ing methods have absolutely no ef-fect on future cash flows, but they willdefinitely affect EPS. And if you hadbeen persuaded by your invest-ment bankers, as Bernie apparentlywas, that the value of MCI-WorldCom shares was your earn-ings per share multiplied by yourindustry P/E ratio, then you mighthave believed pooling accountingwas important.

But if you really believe that EPSis what determines your stock price,then you have no business usingDCF analysis for valuing investments.And you won’t have much use forreal options either. Because the in-tellectual foundation for using all ofthese methods, whether it is DCF orreal options, is that today’s value ismainly a function of the size, timing,and riskiness of future cash flows.Now, this may not be a controversialpoint in this audience, but I will saythat the economic model of valua-tion that we all subscribe to is farfrom accepted in the corporate world.

Real Options and RiskManagement

TRIANTIS: We tend to focus on usingreal options for valuation purposes, butthere is also a lot of emphasis right nowon corporate risk management, andreal options can be useful in bothdefining exposures and then manag-ing or limiting them. To what extent doyou see the focus on risk managementbeing supplemented with a real op-tions perspective?BORISON: My experience with manyfirms is that there appears to be a reallack of clarity about what they aretrying to achieve through risk manage-ment. For example, many energy com-panies have trading floors where theyhedge energy price exposures. How-

ever, it is not at all clear that suchhedging is going to increase the overallvalue of the company. In fact, manyexperts believe that shareholders buyan energy company’s shares becauseof the firm’s exposure to energyprices—in which case, hedging wouldactually be value-reducing.

So risk management, in my experi-ence, is not driven in a clear andobvious way by shareholder value con-cerns, but more fundamentally by otherrelated concerns, such as maintainingprofitability at a business unit level orpreventing illicit activity. Many com-panies could benefit from a muchclearer understanding of how risk man-agement can add value before theymake real options a systematic part oftheir risk management program.McCORMACK: This question aboutthe role of hedging in creating share-holder value is one that I regularlycome up against in my work at SternStewart. Consistent with the academicfinance literature on risk management,my position is that hedging can addvalue for a couple of important rea-sons—and reasons that are particularlyrelevant to the oil industry. One of thebenefits of hedging is that, by reducingthe volatility of cash flows, it allowscompanies to replace some of theirequity with debt. And operating withinrequired repayment schedules, as ageneral rule, should impose somevaluable discipline on an industrythat has a habit of overinvesting inboom times. A second importantbenefit of hedging, perhaps evenmore important than the first, is thatit allows the outside markets to evalu-ate the performance of oil compa-nies without all the “noise” createdby oil price movements. And thisalso means that oil companies cando a better job of evaluating theperformance of their own managers.

In fact, even in cases where an oilcompany does not choose to hedgeits oil price exposure, I often recom-

mend that the company set up aninternal risk management systemthat allows the managers of busi-ness units to lay off part or all of theiroil price risk. By so doing, the mea-sured performance of the businessunits is effectively purged of theeffects of oil price volatility. And thusthe measure of business performanceyou’re left with is one that reflectsmainly just internal operating effi-ciency—how well the managers didtheir jobs—and not whether oilprices happened to go up or downduring the period. Under this sys-tem, even if the company’s overallperformance fluctuates with oilprices, operating managers’ rewardsare insulated from factors beyondtheir control.

The Future of Real Options

TRIANTIS: That’s the end of the formalpart of this roundtable. Let’s now openthe discussion to questions from theaudience.GREG HAMM (cofounder, Pharma-ceutix, Inc.): Michael Mauboussin wastalking earlier about looking at man-agement and their creativity and theirability to exercise options. Is it a dan-gerous path to go down to start think-ing about the value of managementand their creativity as an option; or isthat a place we need to go whenvaluing a company?BORISON: In my experience, whatyou’re talking about is something thatwe typically describe as “corporateculture.” This term always makes methink of a particular company I knowthat appears to generate great ideas,but that apparently just cannot ex-ecute well, cannot put the good ideasinto practice and the bad ones into thetrash can. The company’s stock hasbeen in the doldrums for 20 years, andits staff are the first to admit that theirculture isn’t one in which plans areexecuted effectively. So, while it is

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tough to do this quantitatively, Ithink it is critically important in evalu-ating a company to understandwhether the culture is one that en-courages not only entrepreneurship,or the appropriate exercise of calloptions, but also, when appropriate,the abandonment of failing projects,or the appropriate exercise of putoptions.TRIANTIS: Let’s come back to thesubject of valuation. We typicallyuse real options to value individualprojects within a firm. My questionis: Can real options analysis be usedto value an entire company? It is acomplex problem—one thatEduardo Schwartz, for example, hasaddressed in his series of Internetpricing papers. But I am curious toknow whether or not there hasbeen much effort to come up witheasier ways to value firms based onreal option principles, somethinglike an option-adjusted spread thatis used in the callable bond market.Is there some simpler way of takinginto account the possibility that acompany has options that are com-parable to those represented byspecific firms in its industry? Can weborrow some aspect of the “methodof comparables” to come up with anearnings or cash flow multiple thatreflects the degree of optionality,some metric or rule of thumb thatmight lead to broader acceptanceof real options valuation in practice?BORISON: We once helped a multi-billion dollar mining company valueitself as a portfolio of properties,each of which was treated as a seriesof real options. Our client had tar-geted this company for potentialacquisition, and was dissatisfied withthe available approaches, includingmultiples, for valuing the target anddetermining if paying a premiumover its current market price waswarranted. Our bottom-up analysisindicated that the firm was slightly

overvalued at its current marketprice, so our client decided to tableits acquisition plans. Eventually thetarget company dropped in priceand was acquired by our client.EDUARDO SCHWARTZ (UCLA): Ithink of real options problems asfalling into one of three main classes,or generations, of problems. Thefirst generation is valuing projectsthat offer at least an approximate fitto the Black-Scholes world. An ex-ample is the valuation of gold mines.The risk-adjusted pricing processfor gold has an embedded discountrate that is very close to the risk-freerate. In valuing such a project, youneed to find the risk-neutral distri-bution of cash flows, and then youcan value the mine fairly easily. Thesecond generation of problems in-cludes those cases where the un-derlying assets have traded futurescontracts—assets such as oil or cop-per deposits. Since we can obtainthe risk-neutral cash flow distribu-tion from those traded contracts, itis again fairly easy to value thedeposits.

The third generation of real op-tions problems, however, are thosewhere we try to value real optionsin which the underlying assets arenot traded—which would be true,for example, if you were trying tovalue an Internet company. In thatcase, you need an equilibrium modelto determine the risk-neutral distri-bution of cash flows. And my ques-tion is, how long will it take theacademic finance profession to finda workable solution to this third classof real options problems—one thatcan be used by corporate practitio-ners? It was around 1985 when wefirst started talking about valuingmines; and it probably took tenyears for practitioners to adopt thosemethods. Today we are saying thatyou can use real options to value allkinds of assets. Maybe I’m wrong,

but I don’t see companies using realoptions to value projects where therisk-neutral distributions have to beobtained using an equilibrium model.How long will it take for this aca-demic research to have an effect onthe practice of finance?BORISON: I think it will take a while.It’s in this area where there is thegreatest confusion and disagreementbetween the real options and deci-sion analysis people. The right solu-tion to this problem, in my opinion,is to combine elements of both ap-proaches. That is, in most of thevaluation challenges I run across,there are parts of the problem thatlend themselves to the equilibriummodels that Eduardo is describing—the parts of the problem that involveso-called market or public risks. Butmany projects also involve “techni-cal” or “private” risks where old-fashioned decision analysis is moreapplicable. And this decompositionof the problem into private andmarket risks is, to me, the necessarycondition for gaining broader ac-ceptance of real options in dealingwith this third generation of prob-lems. People will eventually get com-fortable with the idea of breakingdown projects into these two com-ponents, and then using differenttechniques for each. When that hap-pens, there will be much greaterunderstanding and coordination be-tween the two groups. But it will takea while before we get to that point.HAMM: Well, I for one am a littleskeptical about this forecast. We allknow the old story about an econo-mist and a Wall Street guy walkingdown the street. When they see a$100 bill, the Wall Street guy bendsdown to pick it up, but the econo-mist stops him, saying that if it reallywere a $100 bill, it would have beenpicked up already. My question isthis: If real options is this valuabletool that has been lying in the road

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for the last 25 years, why hasn’tsomeone picked it up?EAPEN: As I said before, I don’t thinkthat real options is anything new.This is how good managers havealways behaved. I can’t think of anymanager, faced with a sequence ofdecision points into the future, whowould say, “I’m going to make allthose decisions now, and every timeI reach a decision point, I’ll just rollthe dice, and with some probabilityI’ll go forward.” What we have lackeduntil now is a systematic way offraming that decision process. Andthough we are beginning to get theright tools, we haven’t yet found thelanguage to make it simple enoughso that we can build confidence withmanagers.McCORMACK: I agree with Gill. Pre-viously it was entirely art with noscience—and now it has some sci-ence. But some of the people thatare particularly strong in science areseverely lacking in art. So the ad-vantages of the method are notalways made clear to managers.HAMM: But is there any real evidencethat people are using RO? Can wereally point to some company thatwent to the top of the stock marketbecause they’ve thoroughly integratedreal options techniques?McCORMACK: Merck is a good ex-ample of a company whose CFO hastalked publicly about real options con-cepts—about both decision analysisand real options, in fact—for morethan a decade. And there are a fewexamples in the oil and gas industry.

In 1997, for example, the chairman ofAnadarko made strong statementsabout the use of real options in guid-ing the firm’s development strategy.In fact, I would go so far as to say that,in certain industries such as oil andgas, mining, and pharmaceuticals,there is a fairly clear correspondencebetween success and the adoption ofthese more sophisticated investmentanalysis tools. That is, it is the bestperformers in these industries thatseem to have made the greatest in-vestment to date in understandingand applying these techniques.

Now, there may be some diffi-culty in inferring causality here. Thebest in class may be into real op-tions partly just because they havemore money to spend on it.

But I think the bigger part has todo with the fact that these kinds ofcompanies are often managed bypeople with engineering back-grounds. And when someone findsa way to quantify a process as criti-cal to the value of the company asstrategic planning, managers alreadyaccustomed to dealing with quanti-tative methods are more likely topay serious attention.BOB McDONALD (NorthwesternUniversity): On this point, there’s afamous story about Fischer Black,Myron Scholes, and Bob Mertonhaving the Black-Scholes formulawhen nobody else did, and trying toapply it to find mispriced options.They found only one, and investedheavily in it. But, as things turnedout, they lost a small fortune be-

cause there was a covenant in theoption that they weren’t aware ofwhen they bought it and so didn’ttake account of in their valuation.

So, there’s no question that theBlack-Scholes formula revolution-ized market making in options. But,as this story suggests, market makerswere still doing a pretty good job ofvaluing options even without theformula. It may very well be that thesame thing is happening with realoptions. Managers are using it intu-itively. But the promise of real op-tions is that companies can do aneven better job with the help of thenew models.TRIANTIS: At the same time, havingthe Black-Scholes model allowed morecomplex derivatives to be devel-oped, and allowed options and otherderivatives to be traded in a moreliquid way. Valuation based on realoptions may end up having a similareffect, perhaps to the point wheresome forms of real options actuallytrade as contracts in secondary mar-kets. For instance, options on capac-ity in the semiconductor industrythat are now built into agreementsbetween companies may somedaybe traded in liquid markets.

Well, let’s end on that optimisticnote, and I will close by saying thankyou to all the panelists and to theaudience for a stimulating discussion.My hope is that the next 25 years ofreal options will see even more rapiddevelopment and dissemination ofthese ideas into practice than we’veseen during the first 25.

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