Real-Options Application: From Successes in Asset Valuation to Challenges for an Enterprisewide Approach

Abstract

Summary Various business technologies will distinguish future industry winners. The real-options paradigm is emerging as the state-of-the-art method for asset valuation. The concept of an "efficient frontier" is making headway for portfolio optimization within the energy sector. The notion of enterprise risk management (ERM) is being viewed as far more effective and efficient than the current "silos" in companies' risk-management practices. In addition, proponents of value-based management (VBM) are fostering a more integrated and shareholder-focused approach to performance measurement and accountability. However, a large gap exists in both the literature and in practice on combining real options with portfolio optimization and linking these efforts to ERM, VBM, and the broader business perspective. The ability to integrate and align these disjointed initiatives is of critical interest to senior executives. A seamless enterprise wide approach is needed. This paper discusses some insights and challenges of a real-options application, a portfolio-optimization case study, an ERM method, and a VBM concept. It concludes that, while these approaches are visibly superior to their traditional predecessors, they are limited if applied in isolation. Although the paper does not provide the solution, it proposes a framework for the integration effort that could equip executive management with a cohesive and orchestrated enterprise approach. Introduction " What is it worth?" and "How can the full value potential be realized?" These are the key questions that energy leaders ask today when considering how the increasingly volatile business environment will affect the value of their opportunities and what they can do to respond to the increasing pressure of enhancing shareholder value. The answers lie in an outside-in perspective of shareholder value creation, measurement, management, protection, and delivery in the face of uncertainty and change. Fig. 1 represents a sample of energy firms' enterprise value (the sum of market capitalization and debt), which demonstrates that Wall Street expects firms to create additional value beyond their current assets in place. This additional value is the present value of future growth opportunities.1 Future winners will be those that can correctly value and proactively manage their growth options above the market's expectations while harvesting their existing assets. This is synonymous with the capability of an enterprise wide approach to choose the best strategic directions with superior value potential and to navigate and execute the chosen strategies effectively in an increasingly uncertain and dynamic global environment. In an era of commoditization, convergence, and knowledge, a key to competitive advantage is to use and integrate leading-edge and market-based valuation, portfolio management, risk management, and value-based accountability tools and processes. This allows world-class value creation, protection, and delivery. Real-Options Valuation (ROV) Uncertainty and change create risk but can provide great opportunities in the presence of options. Most business decisions have embedded real options that are not recognized or are misvalued by traditional valuation techniques.2 ROV, an innovation of modern finance and economics, combines the strengths of option-pricing theory and decision analysis. It enables a disciplined and market-based understanding of a firm's real options and their value and helps bridge the gap between corporate strategy and the market's assessment of the firm's worth.3 ROV augments its predecessors in two critical dimensions:discovering uncertainties, options, flexibilities, and dynamic learning andvaluing risky cash flows and appropriate risk adjustment.4