While most valuation methods (e.g., NPV, DA) tend to over- or under-value investments when they attempt to factor in risk and timing (respectively), the Real Options (RO) Method values investments correctly while taking risk and timing into account.
The key to RO is differential risk levels. Unlike NPV, which discounts cash flows (e.g., launch costs, operating profits) at the same amount, RO discounts each of them at a different level of risk.
The method starts with a product/service being proposed, and then considers the many decision and design paths using a Monte Carlo method. In line with the principles of project management principles, one then removes the poorest [financial] outcomes.
As Mathews notes, "a real option is a limited-commitment investment in an asset with an uncertain payoff that conveys the right, but not the obligation, to make further investments if the technology looks attractive." Thus, only the upfront cost is at risk.
RO = Probability of Success x (Operating Profits [given success] - Launch Costs)
Probability of success is discounted using the differential discounting of cash flows, and thus it is the percentage of times in the simulation in which the outcomes [in the Monte Carlo simulation] are successful.
As such, RO is the value of the project given all of the risk, and suggests the maximum amount to invest in R&D. That does not guarantee success, and thus it is crucial to be ready with contingent decisions (terminate, delay and do more R&D, launch immediately).
Much of the value of RO is the thought processes that it inspires. "Real options thinking" involves:
- Gathering all of the information for different scenarios
- Understanding project risk and opportunities
- Making small investments to reduce risk and increase certainty
- Being flexible and understanding contingencies
It sounds simple, but the execution is the tricky part!
Orin C. Davis is the first person to earn a doctorate in positive psychology. His research focuses on flow, creativity, hypnosis, and mentoring, and it spans both the workplace and daily life. He is the principal investigator of the Quality of Life Laboratory and a freelance consultant who helps companies maximize their human capital and become better places to work.