Real Options is the Real Deal

By Vijay Mehrotra

Since my first exposure, I have always been inspired by the use of Real Options software for valuation and analysis of different investments, projects and portfolios. Most of my attraction to Real Options is rooted in pragmatism. The classic discounted cash flow (DCF) analyses that I see — business plans, project valuations, proposals, whatever — are almost always in incomprehensible spreadsheets, invariably full of naÔve but deeply buried, simplified assumptions. These assumptions are usually things like overly optimistic growth rates for sales and revenues and out-of-thin-air discount rate projections. Even before the popping of the bubble, this kind of thing has always made me simultaneously laugh, cry and scream, "Ya gotta be kiddin'!"

I am always inspired by the clever application of different techniques, especially when pulled together to solve a real problem. Real Options methodology combines multiple mathematical tools — dynamic programming, Brownian Motion, control theory — together to produce valuation results. Moreover, this modeling framework provides answers to some fundamental business questions:

- What is this thing really worth?
- What is the right policy to follow as forecasts become actuals?
- How likely is it to be profitable? To exceed certain thresholds?
- What is the worst-case scenario and how often will it be experienced? As a practical person, it seems to me that, when valuing an asset or a cash flow stream, one should take into account: (a) the uncertainty associated with the key forecasts, especially those several periods in the future, and (b) the decisions/controls are at one's disposal along the way, especially when the project is large, risky and/or important.

So imagine my surprise when an old copy of CFO magazine (September 2001) slides across my desk with a headline on the cover that says, "The Problem With Real Options."

I flip open to the article, written by Ronald Fink. (I do not know Mr. Fink, but I hope to.) As I open the magazine, I am expecting to hear about how Real Options analysis can be difficult to understand, or how dynamic programs are computationally expensive to solve. Instead, Mr. Fink's basic premise is that Real Options are highly dependent on the assumption that organizations have the discipline to terminate projects that have been shown to be non-performers during early phases.

He's definitely right about this. But, as I said in my subsequent Letter to the Editor, I think he's missed the real story.

To the Editor: Your article on Real Options in the September issue ("Reality Check," by Ronald Fink) was both misleading and inaccurate in its portrayal of Real Options.

Mr. Fink asserts: (a) that Real Options valuation should only be used if a company has a well-established culture for terminating projects that do not achieve certain performance thresholds, and (b) that using Real Options in any other instance is akin to "putting the cart before the horse."

Regarding the termination of projects, it is well established that companies regularly cut, expand and re-shape projects at various stages in their lifecycles. For example, the downturn in the economy this year has led directly to the delay or cancellation of many, many projects, not only by failed dot-coms but also at the world's largest companies.

While the standard reporting in the press ("1,000 jobs to be cut, 5 percent of workforce slashed") masks the processes that companies go through to arrive at these decisions, the most common Darwinian result is that non-performing projects do not survive, just as Real Options analysis would recommend.

Regarding Mr. Fink's assertion that it is inappropriate for organizations to use Real Options without complete buy-in, this premise is misguided and destined to prove false, for it ignores the demonstrated ability of technology to catalyze change. The clearest of many examples is the personal computer. Ubiquitous today, this basic technology was largely a curiosity 20 years ago. Since then, it has radically changed the speed of organizational analysis, communication and decision-making, eliminating many departments while transforming others.

Are Real Options the right tool for every business analysis? Clearly not. But to cavalierly denigrate the value of this methodology, especially for the reasons that Mr. Fink has cited, is a serious mistake. Not only does his argument miss the mark on Real Options, but he also ignores the reality of today's business world: in many industries as well as in the financial markets, there is more volatility than ever before, making discounted cash flow an increasingly flimsy foundation for significant investment decisions. Real Options provides an alternative that is in many cases more realistic — and safer. End of sermon. Clearly, I have a passion for Real Options. My company has done several projects using Real Options, and we are working hard on developing a spreadsheet add-in for Real Options. This stuff is, in my humble opinion, The Future of Valuation. Getting from the DCF-dominated world of today to the Real Options world of tomorrow will be an adventure. There will be a lot of skeptics, like Mr. Fink, to deal with along the way. But I'm looking forward to it.

Vijay Mehrotra ( is CEO of Onward Inc. in Mountain View, Calif. Neither he nor Onward have a financial interest in Real Options.