Real Options (Luehrman)

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What are Real Options?

Real Options capture the value of managerial flexibility to adapt strategic decisions in response to unexpected market developments. A company creates shareholder value by identifying Real Options, managing of Real Options, and exercising Real Options, associated with its investment portfolio. The Real Options method applies financial options theory to quantify the value of management flexibility, thus turning uncertainty to its advantage in a changing world.

The idea of treating strategic investments as financial options was conceived by Timothy A. Luehrman in two HBR articles: "Investment Opportunities as Real Options: Getting Started on the Numbers" (July-August 1998) and "Strategy as a Portfolio of Real Options" (September-October 1998). In the last article Luehrman says: "In financial terms, a business strategy is much more like a series of options than a series of static cash flows".

Use of Real Options. Benefits

As a result of the above, when valuations involve significant future flexibility or uncertainty and/or future cash-flows alone are close to break-even, flexibility is a major source of value, and option value must be taken into consideration. Note that the first mentioned circumstance is typical for strategic scenarios. And even for strategic decision-making in general.

Formula of Real Options. Calculation

Formula used is Black-Scholes or other similar. Generally, the following variables determine the value of having (an) option(s) - option value:

• Time to expiration (duration).

• Degree of uncertainty.

• Cost of acquiring the option(s).

• Potential cash flows lost, compared to full upfront commitment.

• Risk-free interest rate.

• Expected present value of future cash flows.

By introducing these factors into business decision-making, the Real Options method has enabled corporate decision-makers to use uncertainty for the advantage of the firm, and to create a limit to downside risk.

Forum Forum discussions about Real Options. Applicability of Real Options in Oil and Gas Field Development How to use the real option technique for the appraisal of oil & gas field development projects?... 3   4 comments 🔥 Real Options: Measures to Cut Costs The problem with strategic cost cutting is it is bounded from below by zero. A crisis to one is an opportunity to another if only one knows how to embrace risks.... 2   Real Options Applied to Rapid Labour Mobilization In some industries, the speed of mobilization of labour coupled with the ready availability of skilled labour is a determinant of success, e.g. Oil and gas drilling when prices rise. I would be intere... 1   Start a new topic about Real Options Sign up for free

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Expert Tips Advanced insights about Real Options. Here you will find professional advices by experts. Consultancy Tips Teaching Tips Practical Implementation Tips Key Behaviors of Innovative Organizations Innovation Management, Culture Change, Organizational Change, Innovative Culture, Organizational Culture Many large-scale attempts to make organizations more innovative are experiencing organizational inertia, barriers and/or... How to Become a Self-tuning Enterprise: Advanced Experimenters Organizational Agility, Strategic Agility, Real Options, Emergent Strategy In an HBR article of June 2015, Reeves, Zeng and Venjara argue there's a new way to apply algorithmic principles that en... How to Design Experiments to Support Decision-making on Strategic Innovations Strategic Innovation, Strategic Decision-making, Strategic Experimenting, Experiments, Strategic Testing, Innovation Tes The probability of success of a major innovation is difficult to assess. Statistics and other datasets only provide info... How to Link Risk Management and Strategy? Strategic Risk Management, Best Practices Firms practicing strategic risk management: 1. Create value by embracing risks, shaping risks, and exploiting flexibili... Align Strategy and Risk Management Performance-Aligned Risk Management In a recent white paper titled "Foundations of GRC: Enhancing Business Performance Through Risk Management", which was p... Taking Risk Management from Control and Compliance into a Competitive Advantage Strategic Risk Management Since events tend to be repetitive over time, many management experts support the idea that an effective risk management... Why Society is More Risky than Before Understanding New Risk Categories, Risk Management In his 1992 book "Risk Society: Towards a New Modernity”, Ulrich Beck describes new risk scenarios that companies have t... Real Options and Brand Value Exploiting Real Options A brand can be considered as a feature that allows a firm to gain a unitary profit margin higher than those of products ...

Information Sources Various sources of information regarding Real Options. Here you will find powerpoints, videos, news, etc. to use in your own lectures and workshops. Scenario Planning and Risk Management in Uncertain Business Enviroment Scenario Planning, Risk Management, Strategic Uncertainty Extensive and detailed presentation. Topics: - Integrated Risk Management Framework - Strategic Management Framework ... Important Issues Involving Real Options Real Options, Capital Budgeting This paper by Gordon Sick and Andrea Gamba provides an introduction to real options, as well as highlights some importan... The Six Basic Questions of Risk Management: Introduction to Risk Management Initial Understanding of Risk Management, Risk Management Introduction Managing risk is essentially a process of asking and answering six relatively easy questions no matter what setting (per... Financial Flexibility Option Valuing financial flexibility This model estimates the value of financial flexibility, i.e, the maintenance of excess debt capacity or back-up financi... Delay Option Valuing delay option This model estimates the value of the option to dealy in an investment project. By Aswath Damodaran."... Expand Option Valuing expand option This model estimates the value of the option to expand in an investment project. Modified, it can also be used to assess... Rules of Thumb in Real Options Analysis Real Options Analysis In this normative paper, Giuseppe Alesii derives payback period (PBP) and internal rate of return (IRR) in the presence ... Abandoning Option Valuing abandoning option This model estimates the value of the option to abandon a project or investment. By Aswath Damodaran....

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