What Is Real Options Theory? What Are Its Practical Applications?

August 29, 2019

What Is Real Options Theory? What Are Its Practical Applications?

In life, everyone confronts innumerable options on a daily basis. How do you approach them?

You’re on a diet and you’re counting calories. You have the option of treating yourself with a donut or staying on track with your weight loss goals.

Or maybe you are in a relationship, and your partner proposes: Do you take the option to marry, or do you keep your options open and stay single?

Often the exercise of one option can lead to further optionality. If you eat the donut, maybe you decide to go to the gym after work and burn it off. Or if you resisted the initial temptation, maybe the ice cream in your freezer presents a more compelling argument later that night. Maybe you turned down the proposal thinking someone better will come along. Or maybe you accept, starting a butterfly effect of further optionality: buying a house, having kids, saving for college or taking family vacations.

In business, just as in real life, many options present themselves. How you exercise these options can have material impact on the value of your assets and the profitability of your business. Real options theory applies a decision-making process to support the exercise of these options.

Origination of Real Options Theory

The theory of real options is rooted in the mathematics of financial options, in which the owner of an option may buy or sell an underlying asset at a preestablished price within a given time frame. In short, the owner has the right, but not the obligation, to buy (call option) or sell (put option) the asset at the strike price on or before the expiration date.

Shifting the premise from financial assets to real assets, the owner of a tangible asset has the right, but not the obligation, to make decisions (i.e., exercise options) pertaining to the management and operation of the owned asset. What those options are will vary depending on what the asset may be. Some types of real options are to make an investment or undertake a new project, to defer a decision until a later point or to shut down a project due to unfavorable conditions and then resume those operations when conditions become favorable again.

Using financial options pricing theory you can evaluate the value of your real optionality and manage your assets’ options accordingly.

Let’s take a quick look at a simplified, practical example.

Assume I own a power plant that can be stopped and started periodically. Every day, my power plant presents me with a real option: the option to operate the plant and generate electricity or leave the plant offline. In making the decision of whether to exercise this option, I will evaluate the startup and input costs and the revenues to be generated. I’ll look at the market signals and base my decisions on what I see: If the difference between the price of natural gas (my variable input cost) and the price of electricity (my variable output revenue) is sufficient to overcome my startup costs, I will exercise the option to turn on the plant and generate electricity that day.

Adding a little more complexity to this decision, the volatility of gas and electricity prices may cause me to delay the exercise decision, awaiting a wider difference in the prices. Once I make the decision to exercise (that is, turn on the power plant), I’ve locked in a spread and destroyed my optionality for that asset for that day. But if I delay the decision it’s possible that peak electricity demand hits after noon.

The Value of Optionality

For real assets under my control, I carefully consider the exercise of the options on those assets before making a decision. As with my power plant example, many options are path dependent. As soon as you make a decision and exercise an option, it’s not necessarily reversible. For example, if you own farm ground but decide you’re going to plant the final crop on it (i.e., houses) you can’t undo that decision. Once you’ve exercised that option, you no longer have a farm; you have a neighborhood.

That’s the way you need to think about your assets. Many of the options created by your real assets are finite: You only have so much land or time or capital. My tendency to be careful and make decisions using optionality theory derives from the fact that I operate with a limited source of capital.

If you have unlimited capital, you can target every opportunity that comes along and makes sense. But with limited capital, you’ll need to carefully do deals that are risk-adjusted to provide the best expected return.

The reality is that we all operate under constrained capital. To me, the value of a given opportunity is enhanced if I can determine that it might have some optionality associated with it. If I know an asset has some additional switching value to it, that effectively hedges my investment in it. I can choose to exercise its inherent options down the road as circumstances dictate.

Optionality Applied: How Percipio Puts Real Options Theory to Work

Within Percipio Partners’ investment portfolio, we invest across a spectrum of asset classes. Two of our main focal areas are farm land and residential real estate. Let’s dive into those asset classes to see some examples of real options.

Farm Land

Every year you own farm land, you face a series of options. One of the major switching options we encounter every year is what crop to plant. Situated in the Midwest, you generally have two choices: soybeans or corn. In the last couple of years the switching option has been out of the money because the relative production value of corn has been much higher than that of soybeans (but that isn’t always the case). On top of pricing considerations, there are more practical factors that affect the decision-making process. To maintain your farm land’s soil quality you should not plant the same crop year after year, so even if corn is in the money, you might feel compelled to grow soybeans.

But let’s assume the production values of corn versus beans are relatively balanced in a given year, and it’s not a year when we have to grow corn or beans due to crop rotation considerations. We’ll use real options pricing theory, or even just straight up option pricing, to figure out what to grow on the farm. And with farm land, once you plant your crop, it’s not a reversible option — you’ve destroyed your optionality and you’re locked in to your decision for that year.

This is a great example of why I like to keep my options unexercised for as long as possible. At some point in the spring, the planting window will draw to a close and I’ll have to make a decision. But up until that point, I want to keep an eye on all of my inputs (seed prices, weather and soil conditions, the need for and cost of fertilizer, etc.) in order to inform that decision.

Real Estate

In real estate development, there are a lot of options at play. Initially, if you have a plot of land, you need to make the decision of what you want to build. But once you’ve decided to build residential real estate, your options open up even further. How many units do you want to put in a building? What size? How many 1-bedroom units versus 2-bedroom? What amenities will you put in each unit? What communal features do you want to incorporate?

And once you’ve built your property, further options are presented to you on an ongoing basis. What sorts of renters will you accept? When you turn a property over between tenants, will you just replace the carpet and put on a new coat of paint? Will you upgrade the unit’s features? Or will you exercise the option to do nothing? As in everything, it’s easy to slide backwards in residential real estate if you aren’t consciously trying to maintain or improve the value of your property. If you cut back on maintaining your property it may seem profitable for a period of time, but you will pay for that decision eventually.

When you fully apply real options theory to the decision-making process surrounding your tangible assets, you will understand better than ever before that there is no such thing as a non-decision. Each option you face involves a cause-and-effect proposition. Think about it this way: As in the previous example, nobody gets into real estate wanting to become a slumlord. But continually choosing the option to put off maintenance and upkeep will result in their property sliding down in value and quality.

Each response to an option is a decision, whether it’s a decision to defer action or make a further investment.

Thinking Outside the Box With Real Options

Just as you can own real options, there are situations where you may be short them. Wearing my risk manager’s hat, I am always careful to identify and control my exposure to situations where I am short a real option. Sometimes, though, it seems you can’t avoid it.

A typical example of a situation in which you’re short an option is in an employee/employer relationship. As an employer, you know an employee could always hand in notice and leave your company. You can incentivize them to stay through compensation and benefits packages, but you can’t make them stay. And with incentive compensation, you can’t make an employee give you money back if you’re not meeting an agreed-on budget — but if the business is in great shape, your employees are going to want a share of the success through a bonus structure. And should you need to terminate an employee, you likely don’t have a ready replacement to plug in to the gap; you’ll have to go through a recruitment process and have onboarding expenses once you do find the right candidate to fit your need.

So traditionally, as the owner of a business or from the company perspective, you’re short employee optionality.

But at Percipio, as I said, we seek to ensure we maintain optionality in as many circumstances as possible. And one way we bring that to the market is through our consulting operations.

We outsource a number of operations roles to our clients. Accounting, finance, management, HR — we use Percipio’s employees to provide business operations support in noncritical areas of client businesses. When you outsource your company’s accounting functions to a consulting firm, like Percipio, you can enjoy the benefits of optionality in your staffing situation as easily as with your real assets.

Outsourcing job functions shifts the relationship from employee/employer to business/commercial. Employment becomes continuously scalable, rather than discretely scalable.

In a traditional employment model, you have a business need and hire an employee to fill it. If you realize that role isn’t sufficient to cover the need, then you have to go through the process again and hire a second employee. Or if you need to scale back, it’s much easier to say to a consulting firm that you only need 25 hours of service than it is to tell a full-time employee that you need to bump them down to part time, impacting their salary and benefits. And if an employee takes time off or even resigns, our personnel redundancy model won’t leave us, or you, scrambling to fill the void.

If you fully subscribe to it, real options theory can have a positive impact on every aspect of your business. Give yourself another option today and reach out to me — let’s discuss how Percipio can help you apply optionality to discover untapped opportunities.

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