Sunday, December 1, 2013

'Real Options' Theory and Just About Everything

Remembering Betteridge's Law of Headlines: "Any headline which ends in a question mark can be answered by the word no" we can assume that Thales was not the first user of options although as far as I can tell* he is the first we know of.

From Turnkey Analyst:

Thales-The World's First Option Trader?
...This ancient framework is often applied to modern R&D investments. In R&D investing, firms invest capital up-front, with the hope that the results of the research will enable the firm to commercialize the underlying idea. If the idea turns out to be a good one, the firm can, as Thales did, exercise its option to use it to generate profits, or it can sell the idea to another firm willing to do so. If the idea turns out not to be a good one, then the option expires out of the money, and the firm loses the premium it paid as an up-front R&D investment.

Option theory is really just a way of thinking, but it can be especially useful for valuing certain types of firms, which may not lend themselves structurally to other approaches. For example, traditionally, when valuing projects, financial practitioners have used the discounted cash flow (DCF) methodology; they project cash flows and then apply a discount rate that reflects the riskiness of those estimated cash flows. But the DCF framework has some shortcomings.

Consider the pharmaceutical industry, which consists of research-based firms that are dependent on the success of their research projects. In pharmaceutical R&D projects, DCF valuations do not account for manager’s ability to abandon the project, nor do they distinguish between projects abandoned due to 1) lack of economic viability and 2) safety or efficacy considerations, which have different success rates. Evaluating stages of pharmaceutical R&D projects as compound options allows one to account for these contingent decisions and differentiated risks, and yields higher valuations than does DCF, which systematically undervalues these benefits.

Peter Boehr has written extensively on “real option” theory, which allows a more granular view of contingent value and the value of flexibility. These values can take many forms, such as excess manufacturing capacity, inventory or cash, or such as patents, which confer the right to commercially develop the patented idea.
Robert Bruner has even proposed a matrix for thinking about embedded real option value as a component of total value, and as a guide to strategic planning:
Matrix
In the northeast quadrant, eBay and Human Genomics hold rights to unusual new intellectual property that has yet to be fully developed but that has high commercial potential. In the northwest quadrant, Microsoft and Dell have unusually strong market franchises that grant them some annuity-like business, but also have high option value because of strong flexibility. In the southwest quadrant, Duke and General Mills have strong franchises that grant economic value. And in the southeast quadrant, two bankrupt firms have relatively low economic value and option value. Boer argues that firms can migrate from one quadrant to the next and that strategic planning is about the migration process....MORE
According to the GOOG we've mentioned the old boy four times, first in January 2008's "I'm Pissed at Merrill and Citigroup (MER; C)" and most extensively in 2010's "More on Buffett's Grandfather Clause in the Derivatives Bill (BRK.B; BRK.A)".