Real Options: Another Way To Value Internet Initiatives.

Anyone who has tried to measure the value of an Internet investment has discovered the difficulty of presenting a compelling business case using standard techniques like net present value (NPV) or return on investment (ROI). Projected cash flows seem meager in comparison to the investment required, or the discount rate chosen to compensate for the risk is so high, it renders the NPV unpalatable. Analysts often resort to instinctive appeals of "synergy" or "strategic importance" to compensate for the valuation shortfall, Indeed, many executives instinctively know Internet initiatives have some sort of value that discounted cash flow analysis (DCF) fails to capture. The market value Wall Street ascribes to many dot-coms cannot be derived using DCF, yet billion-dollar companies without a profitable quarter are commonplace. What justification can there be for this apparent irrationality?

The root of the problem is that static valuation methods tend to undervalue investments made under uncertainty. For several years, the oil and gas industry and pharmaceutical companies, businesses characterized by large capital investments with extremely volatile payoffs, have been using "real options" to help them quantify the risks and potential rewards associated with making investments in risky environments.

These characteristics also describe Internet initiatives. Outcomes are extremely uncertain, investments are high and the risk of losing everything is real. Yet the potential upside is huge. Real options recognize that today's investments in Internet projects give investors the choice of pursuing further investments later, if conditions appear favorable, or abandoning the project if the environment has deteriorated. The capital investment made today provides future flexibility that can and must be valued, but is often missed by traditional DCF or ROI measures. Borrowing from both finance and strategy, real options can provide a way to analyze the value of investing in Internet initiatives. This article isn't meant to be comprehensive, but to provide an introduction to the use of real options and how they can benefit companies pursuing Internet initiatives.

Like Financial Options

Real options borrow heavily from the world of financial theory. A call option gives the buyer the right, but not the obligation, to buy a security at a specified price in the future. The buyer of the call option is taking an optimistic view of the security underlying the call option. Similarly, a capital investment today that gives the investor the future right, but not the obligation, to make a further investment is a real option. Many factors influence the value of the option. For example, as the value of the stock (or the present value of the expected cash flows) increases, so does the value of the call option. In fact, real options are directly analogous to financial options in several ways.

There are two types of real options. Growth options enable a firm to increase its future business. Examples include R & D, brand development, M & A, leasing or developing land or, most pertinent, launching an Internet initiative. Flexibility options, on the other hand, enable a company to change its plans in the future. Management can purchase the option to delay, expand, contract, switch uses, outsource or abandon.

Certain critical components of real options make them a powerful analytical tool. First, they recognize and value the flexibility today's capital investments provide. Second, they recognize the staged nature of many investments and explicitly account for the reality that certain of these investments will never be made if, based on additional information developed over time, they are unattractive. In this instance, it makes sense simply to abandon them, rather than pour good money after bad.

In contrast, DCF looks at a series of investments as if they'll be made regardless of whether they still make sense at a later date. For example, the first chart on page 27 depicts a P&C insurance company using the Internet for the first time as a new distribution channel. Under this scenario, it's assumed that the initiative will be launched nationally and is a yes or no decision. There's a 50-percent chance of success because of uncertainty pertaining to market acceptance and the potential backlash from agents.

The second chart depicts the same hypothetical company, but the analysis captures the value created by management's ability to stage the initiative. The firm will first launch a pilot program for online insurance in a small geographic market. Based on the results, it can decide to launch a national campaign or abandon the project. This analysis quantifies the value created by staging an investment. The firm can gain market data before a national launch or abandon a project before spending additional funds. Of course, a real-life example would factor in additional variables, e.g., the time value of money. In this simplified example, the incremental value of the option would be $33.

Additionally, real options compensate for the uncertainty inherent in investments by risk-adjusting cash flows and discounting them at a risk-free rate. DCF, on the other hand, compensates for this uncertainty by adjusting the discount rate. Adjusting cash flows forces analysts to be more explicit about assumptions underlying the projections and eliminates interminable discussions about the appropriateness of one discount rate vs. another.

Another critical difference between DCF and real options is the effect of uncertainty (or risk) on value. Uncertainty typically is considered bad for the valuation of traditional cash flows. In contrast, uncertainty increases the value of real options.

Consider two examples. As time passes, uncertainty is resolved and the present value of the cash flows (analogous to the value of a stock) can be more accurately calculated. If the environment is volatile, the chance that the value of the project in the future will exceed the investment required (or, in other words, that the NPV will be positive) increases. The third chart below shows two investments, one with a wide range of possible outcomes, the other with a relatively narrow range. In the former, more volatile scenario, there's a good chance of producing a project with a positive NPV in the future. Hence, a real option under this set of outcomes would have value. The latter, more stable scenario has no chance of producing a project with a positive NPV. An option using the latter set of outcomes would have no value.

Real options aren't universally recognized as a means of valuing capital investments. Yet neither did the now-ubiquitous capital asset pricing model catch on overnight. Executives involved with assessing Internet initiatives should think at least conceptually about the advantages real options provide.

While addressing the mechanics of calculating an actual value for a real option are beyond the scope of this article, there are several key lessons.

* As volatility (uncertainty) increases, so does the value of the real option

* Implement initiatives with great uncertainty in stages. A small investment up front can give management the ability to resolve uncertainty through data gathering and learning. The larger investment in the future can be made in an environment with less uncertainty.

* Look at a series of initiatives on a portfolio basis: the overall results of the portfolio is what ultimately matters, not the individual performance of each initiative.

* Real options recognize that abandonment is a viable alternative that must be contemplated from the outset; it doesn't necessarily mean the team in charge of the initiative has failed.

* Internet investments may often grant the possibility of pursuing an avenue in several months or years; without the relatively small investment, the opportunity may be foreclosed forever.

* Although real options can be intuitively appealing, arriving at a value is difficult. Determining the exact value of a real option isn't necessarily critical; instead, understanding the drivers of the valuation and the value relative to traditional methods is more important.

If real options are such a useful tool, why haven't they been widely adopted? Any new theory takes time to percolate through organizations used to doing things a certain way (changing a hurdle rate, for example, is often a major challenge). And real options are difficult to explain in a few sentences -- they're a lot of work to communicate effectively. But ultimately, they're helpful in unlocking the value embedded in investments many practitioners know exists, but have been unable to quantify.

Dan Latimore is director of eStrategy at Cambridge, Mass-based consulting firm Mainspring Communications. Reach him at [e-mail]. All contents copyright (c) 2000, Mainspring Communications, Inc. All rights reserved.

Vive le ROI

Matt Goddard

Given the increasing complexity and cost of web-based technology, corporations must justify their investments in an online presence with something more measurable than simply a nagging sense that they're falling behind their competitors. It's time for finance departments to step in.

In the web's early days, IT usually owned site design. The techies were followed quickly by marketing, once the webs communications potential was understood. But now that the Internet is the medium for every type of business process, it's essential for financial executives to be involved from the beginning to make sure the site will deliver measurable bottom-line results.

Most of the following strategies have nothing to do with technology, and everything to do with good business sense. As the web matures, companies will expect web developers to have strong financial backgrounds, in addition to technical and design expertise.

While designing a top-notch web site will always require a substantial chunk of time, energy and money, if you've got a great business, you're on your way to having a great site.

* Prioritize according to profit margins. One of your lesser-known products has a terrific profit margin. So why is information on it buried in the "Other Products and Services" section? Putting your best revenue generators in front is smart, regardless of whether the transaction takes place in your building or on the Internet.

Every home page has an equal amount of "real estate" -- a space limited by the user's screen size. The site's success in generating revenue depends on how that space is divided -- which products and features receive the most "acreage" and the most prominent placement. Ask the big questions: Which products or services are the most profitable, the ones the company can grow on? From there, move to the site's specific goals: Is it more important to emphasize online sales, build brand recognition or give value to advertisers? Then make sure visitors look at the most important parts of the site first -- those that will maximize revenue.

* Cut operating costs. The Internet can create major cost savings if the company makes the right design decisions from the start. Financial executives can identity potential savings and balance those against the investment each part of the site will need. For example, if you built a multimedia product demo into your site, how much less equipment would your sales reps have to use? How many meetings could they skip completely? Similarly, you can post reports and white papers online instead of publishing paper versions, allow users to register for e-mail newsletters or company events and let employees manage their own contact and benefits information.

* Collect data that will help you down the line. Most people assume data collected on the web revolves around customer profiles -- the kind of demographic information DoubleClick and other online ad sales firms collect. However, there's also a wealth of financial information out there. Organizations can quantify which products are selling well online vs. through other vehicles; which customers demand the most attention in terms of e-mails and phone calls; which features -- such as profile-based product recommendations -- drive purchases higher; and other data that will factor into the site's evolving ROI.

* Work with other parts of the enterprise to make the site successful. A company wanted to design a shopping cart for its e-commerce site. Though the design cost tens of thousands of dollars, it perfectly matched the preferences of a wide pool of potential new customers. But by the time the project was finished, the client had run out of budget to promote the site. No matter how much those potential customers might have liked the site, there was no way they'd ever find it! The lesson, obviously, is to keep an eye on the big picture when considering ROI, and stay informed about what other members of the web-design team are doing.

Matt Goddard is president of Impreza (www.imprezadesign.com), a web-communications company specializing in e-commerce return on investment, web-enabled software and graphical user interface design.

                         Options: Financial & Real
                     Correlation of price drivers with
                           price of call option
Price Drivers for          Price Drivers for
Financial Options   Call   Real Options
Value of stock     [Delta] PV of expected cash flows
Exercise price     [nabla] Investment cost
Volatility         [Delta] Project value uncertainty
Time to expiration [nabla] Opportunity expires
Risk-free rate     [Delta] Risk-free rate
Dividend yield     [nabla] Competition - Lost CF