(Real) Option Thinking and Scenarios

Scenarios make us think about more than one future, but we are only asked to come up with one strategy for the future. This creates a tension between scenarios and strategies. (Real) option thinking promises to be able to bridge this gap.

© 1996 Paul de Ruijter and Nico Janssen


Scenarios make us think about more than one future, but we are only asked to come up with one strategy for the future. This creates a tension between scenarios and strategies. (Real) option thinking promises to be able to bridge this gap. Strategies are guidelines for actions. However, real actions which are taken in organisations depend only partly on plans, but more often the current situation and the decision takers image of the future play a more important role. The value of a strategy depends largely on the degree in which it is a real guidance for action and whether this action leads to the desired results. Strategies that are no guidance for action are useless, they are just paper tigers. On the other hand, strategies that are implemented, without taking into account the changing business environment, are also dangerous. A strategy in that case makes a company blind for opportunities, or makes it stick to actions which could have been observed to be wrong half way. Therefore it is needed to build flexibility into strategic plans. Option thinking can provide this flexibility.

Option thinking is not new, it is everywhere. Our whole life consists of options. We don’t know in advance if we’re going to play tennis or watch TV when we come back from work. Dependent on whether we can get a tennis partner, we choose to do the one or the other. The more options you have the more freedom you have, and the more flexible you can react to changing circumstances. In organisations option thinking happens also, but often in an implicit way. Often you can hear managers say that they bought a company for much more than the market value, because the investment “opens up new options”, or they get into new businesses to “hedge their bets”. These “intuitive” actions of managers are often not irrational; we just lack the formal language to explain the rationale behind it. Option thinking is a structured and explicit way of thinking about possibilities, actions and decisions in order to be able to react to future conditions, and even to prepare for these. It provides the rationale for what good managers do intuitively. Every investment project of which the implementation can be delayed or changed or possibilities created for new investments can fall in the domain of option thinking. Option thinking gives an analytic framework to design flexible strategies, making it possible to act in a flexible way to changing circumstances in the business environment or in the organisation. It deals with the creation, acquisition, maintenance, exercising and disposing of options.

Origin of Option Thinking

Options are known from the financial world where they represent the right to buy or sell a financial value, mostly a stock, for a predetermined price (the exercise price), without having the obligation to do so. The actual selling or buying of the underlying value for the predetermined price is called exercising your option. You would only exercise the option if the underlying value is higher than the exercise price in case of a call option (the right to buy) or lower than the exercise prise in the case of a put option (the right to sell). With call options you “insure” yourself against a price increase, with a put option you insure yourself against a price decrease. This right, the option, is only valid for a limited time. Sometimes it is only possible to exercise the right, that is buy or sell for the exercise price, at the end of the running period of the option, but mostly it is possible to exercise the right during the whole of the option period.

Options are valuable because financial values fluctuate over time. Where strong fluctuations (high volatility) lower the price of a stock because the increased risk, the price for an option increases, because with stronger fluctuations the chance that the underlying financial value exceeds the exercise price increases. The price that you pay for the option to buy or sell is called the option premium. By buying options you create for yourself the possibility to profit from price changes, both upwards and downwards.

Financial versus Real options

Real options in option thinking are based on the same principals as financial options. To have a “real option” (as opposed to a financial option) means to have the possibility for a certain period to either choose for or against something, without binding oneself up front. Real options are valuable because they incorporate flexibility. Economic activities and decisions can be valued using the analogue option theories that have been developed for financial options, which is quite different with from traditional discounted cashflow investment approaches.

In traditional investment approaches investments activities or projects are often seen as now or never, irreversible, not divisible, ending and stand-alone. The question is whether to go ahead with an investment yes or no. Formulated in this way it is very hard to make a decision when there is uncertainty about the exact outcome of the investment. To help with these tough decisions valuation methods as Net Present Value or Discounted Cash Flow have been developed. And since these methods discount heavily for external uncertainty involved, many interesting and innovative activities and projects are cancelled because of the uncertainties. The point is, however, that only a few projects are now or never, irreversible, not divisible, ending and stand-alone. Often it is possible to delay, modify or split up the project in strategic components which generate important learning effects (and therefore reduce uncertainty). And in those cases option thinking can help.

The fact that real options are like financial options does not mean that they are the same. Real options are concerned about strategic decisions of an organisation, where degrees of freedom are limited to the capabilities and identity (history) of the organisation. In these strategic decisions different stakeholders play a role, especially if the resources needed for an investment are significant and thereby the continuity of the organisation is at stake. Real options therefore, always need to be seen in the larger context of the organisation, whereas financial options can be used freely and independently.

Linking option thinking with scenarios

Scenarios can be used to help with seeing, creating, evaluating and timing of options. Identifying options is the logical next step after developing scenarios. Scenarios actually create the need for new ways of thinking about investment decisions. With single line forecasts, simple discounted cash-flow analyses work. When you assume a given “certain” future, you can simple calculate whether to invest or not. But if you assume that the future is uncertain traditional investment evaluation tools can no longer be applied in the same way. Multiple assumptions about the future (scenarios) imply that the same discounted cashflow formula needs to be recalculated for each scenario, because in every scenario important variables can differ like interest rates, inflation, market uptake of new technology etc. And instead of resulting in one clear yes or no, this could mean that some investments are positive in one scenario, but negative in an other. This means that deciding what to do becomes very difficult. This is where option thinking comes in.

Option thinking is made to deal with uncertainty. So, after scenarios have been developed, every scenario can be thought through to look for new possible investments, one scenario at a time. These investments can be evaluated using the assumptions in the scenarios in the discounted cashflow calculations. An investment/scenario evaluation table could look like this, with ++ for positive DCFs and – for negative DCFs.

Investment/Scenario Scenario A Scenario B Scenario C
Investment 1 ++ ++ ++
Investment 2 – – ++
Investment 3 – ++ ++

Investment 1 is robust; it can perform well in every scenarios. Here it is assumed that whatever happens in the outside world, the investment is a wise decision.

Investment 2 is not robust; it would only perform well in scenario C. If this would be very lucrative in scenario C, and we wouldn’t want to discard this opportunity, it is possible to try to decompose the initially proposed investment to find the minimal part that still guarantees the ability to do the full investment eventually. In that way we create a call option, allowing to grasp the upside while limiting the downside. In the scenario process early warning signals could be identified that indicate triggers for further commitments to the investment.

Investment 3 is not robust; it would perform badly in scenario A. Here it is possible to see if it is possible to invest, while at the same time creating the ability to get rid of this investment if and when needed, creating in effect a put option. This could be done, for instance, by investing in a company and at the same time not integrating it in the mother-company, leaving it as a separate entity with a separate brand-name and management. This allows for quick selling when scenario A is felt to be developing. Again, the scenarios can be used to identify early warning signals that indicate that it is sensible to disinvest.

Option thinking tries to bridge the gap between scenarios and strategic plans and between strategic plans and action, by explicitly creating flexibility into strategy. Option thinking provides a language to discuss conditional decisions, integrate early warning signals in planning, and it makes explicit the need to sometimes wait in order to learn more before making decisions. This does not mean that managers now need to start elaborative calculations to help them with their decision-making. For many investments it is not even possible to quantify all the variables that are needed to actually calculate the value of options. But it does help to understand when traditional investment analyses oversimplify. Just knowing the principles of the value of options helps in redefining investments, and with making better decisions. The following taxonomy of options could help managers to see and create options.

A taxonomy of options

Real options can be classified in different ways. One distinction is between inherent and created options. Inherent options don’t need special activities to be obtained or maintained, they are just there, for free. You just need to see them. An example is stopping projects or business activities, although the exercise price for these options are mostly very high. In general inherent options are of the types: start, stop, temporarily stop, delay and pick up. These are also called control options. The most important thing in inherent options is the awareness that they are there and that you have the ability to use them. Created (or proactive) options need to be consciously created or maintained. Created options are created with future conditions in mind. Especially if a company tries to prepare for more than one future (e.g. using scenarios) it is possible that it wants to have options to survive in different worlds. Examples are oil companies which have a stake in a small photo-voltaic energy company and steel drum companies that have a research activity in plastic drums. This gives the company flexibility, the choice to enter new markets in the possible situation when their existing market declines.

Another way to classify options are switching and modification options (options of the operational type). Switching options give the possibility to switch between production means, inputs or business activities. Switching options are based on the multiple applicability of a certain capability. An example is a company that can use both oil and gas as an energy input. This leaves a choice for both inputs open and final decisions can be made on the basis of changing prices of both over time. Modification options are the capability to change the amount or implementation of the activity or project. Examples are advertisement campaigns that can be up- or down scaled or changed over time.

Another type of options are platform options. Platform options are the result of investments in capabilities. Platforms give the company the opportunity to start lucrative new businesses. The platform act as a basis from which the company can operate. The company has the choice whether, when and how strong to start those new businesses up. Examples of platforms are distribution channels in different countries. Via these channels a company can choose to deliver different products. Which and how many products will be delivered can be made dependent on the future external conditions. But also specific capabilities can work as a platform. With the same capability in micro-electronics, a company could choose to go either into cellular phones or walkmans or something else. Investments in these platform options need to be related to many possible conditional businesses. The more businesses a platform option opens, the more valuable the option is.

An options approach to strategic management

Phasing and scheduling of projects which are related to each other can make a huge impact on the value of that set of projects. By phasing and scheduling projects, every step in a project opens or closes the possibility for further options. This is called a chain of growth options, or a compound growth option. For example, to make money with new modems you need to be able to make communication chips and you need a distribution channel. If the risk is very high in making new chips, you first try to develop that, before you decide to create a new distribution channel. So if the development of chip fails, the costs of building the distribution channel can be saved. But if the highest risk is in the distribution channel, trying to build that first can save you the cost of making the chip. It is mostly cheapest to do the activity first that reduces the largest part of the risk for the lowest cost. Creating options can buy you time to think and gain information to decide whether or not go ahead with a certain bigger investment. But when a project finally gets “in the money” you still need to decide whether or not to exercise the option at that moment. Good early warning signals, which can indicate the profitability of certain projects, can be very useful in this respect. Take for example a company which is thinking about building a one billion dollar plant in Russia. Instead of making this into a yes/no discussion it could start with exporting to Russia, using a small local office, and defer the big decision to build the plant for a year. In that year the company can test the market for it products, get more insights in to the political situation, and it gets a better idea about when to buy land and where to build the location. It could even buy a plot of land and start the design of the plant, without making a final decision on whether to build the plant. All these actions could be labelled as the creation of call options, while waiting for the right exercise date. Scenarios are very helpful in such a case, to be able to interpret early warning signals, for instance about political stability and economical development of Russia. The early warning signals could work as “triggers” to make the final decision.

There is a danger, however. Options can freeze you in. Over time, while taking small steps, you could get committed too highly in a certain investment, and you find yourself passed the point of no return and the investment becomes irreversible. On the other hand, you might have waited to long, and somebody else has beat you to it. Timing is everything.

© Paul de Ruijter is an Amsterdam based Business Engineer working with Global Business Network Europe. Nico Janssen is an Investment Analyst currently working for the Bank of Dutch Cities. With many thanks to Jaap Leemhuis, Gerald Harris and Sartaz Ahmed of GBN for their comments.