Vince:

You may inteersted in the following interview which appeared on ERisk.com last Friday. Were Rick Buy's comments about real options taken out of context?


                                  Yann Bonduelle leads a 25-person team for PricewaterhouseCoopers in London
                                  that applies decision analytics and real options theory to dilemmas ranging from
                                  valuing a biotechnology product to deciding whether to kill off an Internet financial
                                  services business. Here he talks to Rob Jameson about whether this "theoretical"
                                  approach to risky decision-making really helps businesses in their day-to-day
                                  balancing of risk and reward. Yann holds a Ph.D degree from the
                                  Engineering-Economic Systems Department at Stanford University, where he
                                  studied how to apply engineering decision and design analysis to wider economic,
                                  social and business issues. He then worked as a consultant applying his decision
                                  analysis methodologies to problems that included consumer decision making
                                  about innovative products such as electrical vehicles, before joining the
                                  PricewaterhouseCoopers team in 1998  where he is now a partner. He has
                                  written widely on the application of real options, particularly in fields of life
                                  sciences, technology, and e-business, and has a special interest in the
                                  relationship between risk assessment, validation of risk data and financial
                                  valuation.

                                  How would you sum up your approach to business decision analytics?
                                  Most of our projects are set up to help businesses that face massive uncertainties
                                  of some kind. Decision analysis helps people explore problems, and redesign
                                  their decision-making process to increase the chance of them making the right
                                  choices. For example, imagine a biotechnology company that has to decide
                                  whether to put itself up for sale, enter a strategic relationship, or continue to go it
                                  alone. Each of those options will lead on to other value-enhancing or
                                  value-destroying scenarios. We work with the client firstly to understand and
                                  challenge the assumptions associated with their most likely business
                                  development scenarios, and secondly to help them identify decisions that would
                                  help protect or increase the value of their technology or company. Quantifying
                                  technical, regulatory or commercial risks can sometimes be a challenge. In
                                  technology-intensive fields, however, we have found that managers (often
                                  scientists) are quite willing to describe the main sources of risk and to assess the
                                  probability that a risky event may or may not occur.

                                  How does this kind of risky decision-making relate to real options valuation?
                                  You can't say what the value of an asset is until you decide what you might use it
                                  for. This means that, to form an opinion about the value of an asset, you must
                                  explore the most important decisions that you are likely to face and that will have
                                  a significant impact on the value of the asset. So decision analysis helps to define
                                  the business problem and to uncover a stream of inter-related choices that are, in
                                  effect, "real options". For example, if a company is trying to decide whether to
                                  invest in a risky project, does it have the option to pull the plug on the investment
                                  at an early stage if a pilot project gives a poor showing? That "real" option reduces
                                  the riskiness, and increases the potential value, of the original business plan. So
                                  real options and decision analysis are really very close to one another. But you
                                  don't have to believe in real options valuations to find decision analysis useful.

                                  What do you mean?
                                  Often decision analysis can help managers to identify the key risks in a strategic
                                  decision, attach weights to these, and show clearly how they interact. For many
                                  companies this "risk discovery" is the most valuable part of the exercise.

                                  Real options theory has been criticised recently for being, well, not very realistic.
                                  Is it a practical approach to valuation?
                                  It's important not to hold out unrealistic hopes for the real options approach to
                                  valuation. But it's an exciting methodology, and it's also sometimes the only
                                  reasonable way of tackling a very practical problem. For example, when a firm
                                  sells an asset, the firm might have to make an independent valuation of the asset
                                  for legal or corporate governance reasons. But in many businesses today there
                                  are assets that simply cannot be valued in traditional ways because they are
                                  difficult to link to cashflows. The cashflows might not exist because the business
                                  is so novel, or they might be hidden. In some respects, a real options analysis is
                                  much closer to reality than a traditional valuation.

                                  How, exactly?
                                  The classic way of valuing a future business is to base the calculation on a single
                                  discounted cashflow that is projected from the activity. But this doesn't really take
                                  account of the way that scenarios can change, or the fact that managers can
                                  react to situations as they unfold. I mentioned earlier the option to kill a project or
                                  business at an early point. But the upside is that if a pilot project yields exciting
                                  results, it might allow you to invest more quickly and reach a revenue-generating
                                  position in a much shorter time than the original business plan allows. So to value
                                  a future business we really need to look at the cashflows that might arise in a
                                  number of scenarios. This is "realistic" in that, if the project gets the green light,
                                  you can bet that its managers will be taking that kind of decision on the ground all
                                  of the time.

                                  What's the most challenging part of mapping out a decision analysis tree?
                                  Modelling the links between the variables in the decision tree -- it's something we
                                  have particular strengths in. But it's also tricky to know when it's worthwhile to
                                  add on more detail, and when it's better to draw back.

                                  In a recent ERisk interview, Rick Buy, chief risk officer of Enron, said that over
                                  the two years that Enron had experimented with the real options concept, it had
                                  found it of "limited, but not zero, use". Why is there a slight air of cynicism about
                                  real options in some businesses today?
                                  It's strange that Enron would profess this attitude. A few years ago, it was widely
                                  reported to have used real option valuation to support a very profitable purchase
                                  decision. They had apparently bought cheaply some older generators in the US
                                  that generated electricity at a very high cost. They knew that they could mothball
                                  them for most of the year, and switch them on only when the electricity prices
                                  were sufficiently high. Nevertheless, from a customer's point of view, there might
                                  have been too much hype about the methodology. One problem in the application
                                  of real options technology is that there are, perhaps, too many people trying to
                                  tweak reality to conform to their "perfect" model. It's better to aim for something
                                  pragmatic that clearly improves decisions over time. In one pharmaceutical
                                  company we worked with recently, we worked together to improve their valuation
                                  analyses by moving from a single discounted cash-flow methodology to one that
                                  took into account a rather small set of business scenarios. It would have shocked
                                  some academics and consultants, but it was an undeniable improvement on the
                                  original approach.

                                  Why do you think financial institutions are only just picking up on your field, when
                                  it's been applied in the energy industry for 15 years or more?
                                  It might have something to do with the relative stability of the banking world until
                                  recently, and the relatively high margins that banking lines have enjoyed. Also,
                                  industries such as energy and pharmaceuticals tend to have more people with an
                                  engineering and science background. The dynamic modelling of decisions is
                                  based on methodologies originally dreamed up to help engineers design electrical
                                  and electronic systems. This approach is quite distinct from the Black-Scholes
                                  options analyses that the banking world is familiar with: the Black-Scholes
                                  approach is difficult to apply in a real options context, because everything
                                  depends on the assumptions that you put into the Black-Scholes model. The real
                                  options approach, on the other hand, is in a sense a way of modelling those
                                  assumptions more explicitly. But banks are now adopting some of the thinking,
                                  particularly in terms of using decision analysis to pinpoint risks and identify
                                  value-enhancing decisions, and in using real options methodologies to sort the
                                  wheat from the chaff in their more speculative investments.

                                  You mean their Internet investments?
                                  We have recently worked with a major Dutch bank that had arrived late in the
                                  Internet game, and then made a considerable number of investments. Now that
                                  even B2B business models have questions marks hanging over them, and many
                                  B2C businesses are already under water, they wanted to work out which
                                  investments might contain real value. In this situation, it's a case of ranking
                                  priorities and helping the bank make sense of what could turn into a
                                  decision-making chaos, rather than sophisticated valuation. It's not just a case of
                                  whether an internet investment should be killed off, but the problem of whether
                                  continued funding for it should take priority over budget demands for major IT
                                  upgrades in existing businesses, and so on. These are very practical questions
                                  and they have to be answered somehow.

                                  Are there other areas in financial institutions that seem accessible to this
                                  approach?
                                  Yes, for example, we think it can help work out the value associated with various
                                  approaches to marketing a new bank business line. At the moment, many banks
                                  are chasing high-net-worth individuals, but it's not always clear which kind of
                                  individual a particular bank should decide to pursue. The bank might have a
                                  regional or industry advantage already in one particular area, for example, music
                                  business people. But what is the churn rate associated with this kind of
                                  customer? What is the profitability associated with the customer segment? Will
                                  the time and cost benefits of the advantages the bank has in the sector outweigh
                                  any disadvantages? Weighing up this kind of complex problem, where one thing
                                  leads to and depends on another, is what decision and real options analysis is
                                  good at.

                                  Is there any way of rigorously backtesting or validating real options valuations?
                                  In all honesty, not really. The problem is that by the time the option is exercised,
                                  many of the variables surrounding it will have changed, so it's difficult to compare
                                  our original analysis with how things turn out. However, the value of the analysis
                                  comes not only from the final number ("the value of this asset is X") but also from
                                  providing a thorough process, an outsider's point of view, an understanding of the
                                  sources of value and, in short, a bit of clearer thinking.

                                  If real options are so important, why are they so rarely cited in communications to
                                  shareholders and equity analysts?
                                  The battle is still to convince companies to use real option valuations as a
                                  significant part of their internal analysis. Even in major companies in the oil & gas,
                                  and pharmaceutical sectors, where the ideas have taken some root internally,
                                  there seems to be a lot of reluctance to use them in external communication. We
                                  are working with analysts to understand better what they need to if we are to move
                                  things on to the next step.

                                  How does the riskiness of a business, in terms of the major strategic dilemmas it
                                  faces, relate to its share value, and its capital structure?
                                  That's a big question. It's related to work my colleagues do on the optimal
                                  debt-to-equity capital structure and gearing of a corporation, which in turn arises
                                  out of the likely revenue and cost volatilities of the business. The more volatile the
                                  business, the less gearing it can sustain, and the higher the cost of capital. Our
                                  work touches on this in the sense that exercising (many) specific real options can
                                  allow a firm to change its nature, and thus also its risk profile. One classic
                                  example is the pharmaceutical industry. A host of different kinds of companies
                                  service that industry from "big pharma" companies through to smaller
                                  biotechnology startups and run-of-the-mill contract research organisations. A
                                  contract research organisation is often operating within a very competitive
                                  environment with relatively few risks--it does not invest in drug development itself
                                 -- but also very thin margins. But in fact, a few of these companies have used the
                                  skills and knowledge they have developed to become much more substantial and
                                  profitable healthcare companies of various kinds. It's an example of a company
                                  exercising the real options that lie within its skills and assets to transform its own
                                  identity.

                                  Rob Jameson, ERisk