Realizing the Potential of Real Options: Does Theory Meet Practice?

Abstract

The idea of viewing corporate investment opportunities as “real options” has been around for over 25 years. Real options concepts and techniques now routinely appear in academic research in finance and economics, and have begun to influence scholarly work in virtually every business discipline, including strategy, organizations, management science, operations management, information systems, accounting, and marketing. Real options concepts have also made considerable headway in practice. Corporate managers are more likely to recognize options in their strategic planning process, and have become more proactive in designing flexibility into projects and contracts, frequently using real options vocabulary in their discussions. Thanks in part to the spread of real options thinking, today's strategic planners are more likely than their predecessors to recognize the “option” value of actions like the following: • dividing up large projects into a number of stages; • investing in the acquisition or production of information; • introducing “modularity” in manufacturing and design; • developing competing prototypes for new products; and • investing in overseas markets. But if real options has clearly succeeded as a way of thinking, the application of real options valuation methods has been limited to companies in relatively few industries and has thus failed to live up to expectations created in the mid- to late-1990s. Increased corporate acceptance and implementations of real options valuation techniques will require several changes coming together. On the theory side, we need more realistic models that better reflect differences between financial and real options, simple heuristic methods that can be more easily implemented (but that have been carefully benchmarked against more precise models), and better guidance on implementation issues such as the estimation of discount rates for the “optionless” underlying projects. On the practitioner side, we need user-friendly real options software, more senior-level buy-in, more deliberate diffusion of real options knowledge throughout organizations, better alignment of managerial incentives with long-term shareholder value, and better-designed contracts to correct the misalignment of incentives across the value chain. If these challenges can be met, there will continue to be a steady if gradual diffusion of real options analysis throughout organizations over the next few decades, with real options eventually becoming not only a standard part of corporate strategic planning, but also the primary valuation tool for assessing the expected shareholder effect of large capital investment projects.