Transcript Breaking Down The Fears and Misconceptions

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Adopting Real Options as an
accessible and user friendly tool
within your organisation.
David Houldridge
Technology Valuation Manager
E-mail. [email protected]
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Contents
 Overcoming
Barriers to adoption
– Why they may exist.
– How Smith & Nephew overcame some.
 Upside
of using options
– What it may lead to
 Practical
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advice on using Real Options
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Innovation from Objectives
“The innovation process must be set at the highest level of the
corporation by identifying goals and priorities, ... The
targets you set must be clear and challenging, for you
cannot wait for innovation just to show up at your
company one day. But you need not, and should not,
possess the entire solution to the challenge you set. You
have to be sure…that that you raise is realistic, though
it might appear impossible.”
-Akio Morita - Sony Corporation
The Innovation Lecture London Feb 1992
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Why do barriers exist?
C = SN([Ln(S/X)+(r+2/2)t]/t) Xe-rtN([Ln(S/X)+(r-2/2)t]/t)
V= Ge-rt d(k,h;r)-Ke -rt d(k-t*,k-tr-K*e -rt D(kt*
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Culture
 “Successful
investment risk management is
dependent on the right company culture
being in place, so chief executives and senior
management must take a major interest in the
development and application of their procedures.”
From Strategic Investment Decisions. Harnessing opportunities managing risks. L Krantz, A Thomason. FT/Prentice Hall. London.1999.
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Accountants?
“The challenge from the point of view of the finance
department is to put parameters around curiosity and
determine what is and what is not productive. After all, our
success or failure in R&D won’t result from the quality of
our scientists alone; it will also come from the quality of
our thinking about where to invest”
Scientific Management at Merck. - an Interview with CFO Judy Lewent. Harvard Business Review, 1994.
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Company characteristics
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Rules
“Quality” systems
Planning
‘Bean counters’
Predictability
Tasks
Budgets
Assets
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vs
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Flexibility
quality “Systems”
What ifs
Investors
Uncertainty
Objectives
Resource Flexibility
Knowledge
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“Typical” decision maker characteristics
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Intuitive
Computer averse
Short attention span
Skim readers
Set in ways
Make ‘long lasting’
decisions
Are right most of the
time
Have invested a lot of
themselves in the old
way
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
vs

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Analytical
Utilise technology
Focussed
Flexible
Accuracy is not
needed
Conceptual
Knowledge
gathering
Utilise “Team”
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Intuition
 Decisions
based on intuition are commonly flawed
because of bias and missing or misleading
information.
From Strategic Investment Decisions. Harnessing opportunities managing risks. L Krantz, A Thomason. FT/Prentice Hall. London.1999.
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Proper analysis
 Alternatively,
proper analysis may be discouraged
because it is seen as
– too complex to conduct,
– too time-consuming,
– too costly or ineffective.
 Individuals
may prefer to rely on intuition, ‘gut
feelings’, to determine their course of action.
From Strategic Investment Decisions. Harnessing opportunities managing risks. L Krantz, A Thomason. FT/Prentice Hall. London.1999.
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Black Box Mentality
What decade did your decision makers learn their trade?
Inputs
What was the current state of technology at that time?
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Output??
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Advisors
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What are they employed
for?
How much have they
invested in their advice?
How much has the
company invested in their
advice?
Do they know their job?
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Flicking the switch
 How
do we get them turned on?
GO
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Spreading the ‘Word’
 Assumption:
being right will not gain support and
buy-in.
 Permeation will occur when and where
weaknesses allow it.
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Let them adopt it for their needs
Smith & Nephew for example
 Lead customer
 Early adoption by a big customer
 Raised as questions in other business situations
–
Just communicated with examples for discussion
Raised awareness of opinion leaders within S&N
Used as part of idea selection
– adoption by scientists / project leaders.
–
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Not imposed on middle management
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Key diffusion issues within Smith
& Nephew
 Broadly
–
Justified gut feel projects that other methods throw out.
 Key
–
enablers in place to allow adoptions
Forecasting, Portfolio management
 Solution
–
accepted need
not threatening to top management
Presented as a decision support tool for top management
 Methodology
allowed better representation of key
information
– Presenters and recipients were more comfortable
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Luehrman Portfolio
GRC Project Portfolio
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Consider Carefully
Probably
Invest
Cum Volatility
6
5
4
BUILD
3
2
HOLD
1
NEVER
-2.0
-1.5
NOW
0
-1.0
-0.5
0.0
0.5
1.0
1.5
LN(Value/Cost quotient)
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2.0
2.5
3.0
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When do “Real Options” make a
difference?
 Traditionally
– If Return is >>> Investment

“No Brainer”
– If Investment >>> Return

 Look
“Kill”???
for marginal calls, where the decision maker
has a vested interest.
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Comparison of Methods
Value
Option
£0
DTA
Project Lifetime
DCF
From
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Vrettos & Steiner.In Vivo May 1998, p27-32
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Pet projects
 Tissue
Engineering ten years ago?
 Traditional approaches with negative £ value led
to
– “gut feel”
– Soft items
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Science
Ambition
Legacies
Real Options can incorporate gut feel especially where it
relates to upside £
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Reducing Uncertainty and Expectations
Max
NPV
Actual
Outcome
Min
Time
Possible outcomes at review dates
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Managing Uncertainty -
after Newton and Pearson
Regulatory
Likelihood
Development
Project Timeline
End of Research
Project start
Return
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Qualitative and Quantitative
 The
risk management process requires the
integration of qualitative and quantitative
analytical support in an iterative cycle of
management activities through the whole life of an
investment.
 The quantitative analysis tests the insights and
conclusions developed during the qualitative
analysis by producing real dimensions required for
most decisions.
From Strategic Investment Decisions. Harnessing opportunities managing risks. L Krantz, A Thomason. FT/Prentice Hall. London.1999.
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Opening up opportunities that
may have been dismissed
 Volatility
– Our volatility is limited by the thoughts of the
organisation?
– What if?

Should lead to how?
?
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££££
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Setting targets and Contingency levels
Cumulative Probability
0% 20% 40%
60% 80% 100%
Maximum Cost
Target Cost
Expected
Target
100%
80%
60%
40%
20% probability of attaining
schedule target
Time (years)
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20%
0%
Cumulative Probability
Latest Finish
Expected Finish
20% probability of attaining
cost target
Target Finish
Minimum Cost
Earliest Finish
Total Cost (£)
Expected Cost
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Raising targets

How often do you get…
– “I can guarantee to deliver that”
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Does this lead to rapid growth
or maintenance of the status
quo?
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Commitment or committed?
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Intangible assets
 Intelligent
use of Real Options can lead to a
“valuation” of intangibles such as Knowledge,
patents…
 Relies on definition of the work and imposing
decisions after the acquisition of the intangible.
NOW
Decision Point
££
STOP
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££
££
FUTURE
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Upside of risky decisions
 Given
that some of our investments will fail, how
do we know our more risk acceptance culture will
pay back?
– If we are risk averse, why should we change our
nature?
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Our Current Portfolio is low risk.
Risk comfort line
New Products
Current Products
Current Markets
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New Markets
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Total accumulated revenues, 1976 –1994, of all
companies employing each entry strategy
From: Clayton M Christensen, The opportunity and threat of disruptive technologies, 1997
New Products
Total Revenues Accumulated
by all firms, 1976 -1994
$237
Total Revenues Accumulated
by all firms, 1976 -1994
$14420
Average per Company
$16
Average per Company
$1800
Total Revenues Accumulated
by all firms, 1976 -1994
$3056
Total Revenues Accumulated
by all firms, 1976 -1994
$36050
Average per Company
$83
Average per Company
$1500
Current Products
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Current Markets
New Markets
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Level of accuracy
 If
the future is uncertain why do we need to be
certain about now?
 What
are we trying to do?
– Justify this piece of work?
– So how positive does it need to be?
 If
the precision improves our thinking on the
model of the future it is worthwhile, otherwise…
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What are we valuing?
max

C = SN(d1) - Xe-rtN(d2)
t
S
C
YES
NO
C,X,S all in £
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X
min
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Simple software allows easier
examination of inputs
Sensitivity Analysis
-0.60
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-0.50
-0.40
-0.30
-0.20
-0.10
0.00
0.10
0.20
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Qualitative and Quantitative
 “Whenever
we are tempted to further refine our
scoring of uncertainties, we should ask ourselves
if we are attempting to use qualitative analysis to
produce quantitative measures.”
From Strategic Investment Decisions. Harnessing opportunities managing risks. L Krantz, A Thomason. FT/Prentice Hall. London.1999.
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Real world scenarios into real
options calculations
 Five
data points
 Have an NPV (S)
 Have Cost (X)
 Know T-t
 R is often given
 Sigma – guess or use Pert methods
 Quick Black - Scholes, change variables and
understand what happens when the calculation
goes belly up off we go.
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Pert Method of Forecasting
 EV
= (a + 4m + b)/6
 s.d = (b-a)/6
a
= pessimistic
 b = optimistic
 m = most likely
 Needs
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experts!
= s.d/EV
Can use Delphi approach
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Management
 Successful
investments are not delivered by
analysis alone and management of both objectives
and risks must continue throughout the whole life
of an investment.
From Strategic Investment Decisions. Harnessing opportunities managing risks. L Krantz, A Thomason. FT/Prentice Hall. London.1999.
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Speculation and Investment
 “Speculation
is an effort, probably unsuccessful,
to turn a little money into a lot. Investment is an
effort, which should be successful, to prevent a lot
of money becoming little.”
– Fred Schwed – FT 22/11/99
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