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Transcript of Houldridge real options 2000
DGH/ROG/06/00
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Adopting Real Options as an accessible and user friendly tool within your organisation.
David HouldridgeTechnology Valuation Manager
E-mail. [email protected]
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Contents
Overcoming Barriers to adoption– Why they may exist.– How Smith & Nephew overcame some.
Upside of using options– What it may lead to
Practical advice on using Real Options
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Innovation from Objectives
“The innovation process must be set at the highest level of the corporation by identifying goals and priorities, ... The targets you set must be clear and challenging, for you cannot wait for innovation just to show up at your company one day. But you need not, and should not, possess the entire solution to the challenge you set. You have to be sure…that that you raise is realistic, though it might appear impossible.”
-Akio Morita - Sony CorporationThe Innovation Lecture London Feb 1992
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Why do barriers exist?
C = SN([Ln(S/X)+(r+2/2)t]/t) - Xe-rtN([Ln(S/X)+(r-2/2)t]/t)
V= Ge-r d(k,h;)-Ke -r d(k-k--K*e -r D(k-
Long Term Capital Management
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Culture
“Successful investment risk management is dependent on the right company culture being in place, so chief executives and senior management must take a major interest in the development and application of their procedures.”
From Strategic Investment Decisions. Harnessing opportunities managing risks. L Krantz, A Thomason. FT/Prentice Hall. London.1999.
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Accountants?
“The challenge from the point of view of the finance department is to put parameters around curiosity and determine what is and what is not productive. After all, our success or failure in R&D won’t result from the quality of our scientists alone; it will also come from the quality of our thinking about where to invest”
Scientific Management at Merck. - an Interview with CFO Judy Lewent. Harvard Business Review, 1994.
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Company characteristics
Flexibility quality “Systems” What ifs Investors Uncertainty Objectives Resource Flexibility Knowledge
Rules “Quality” systems Planning ‘Bean counters’ Predictability Tasks Budgets Assets
vs
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“Typical” decision maker characteristics
Intuitive Computer averse Short attention span Skim readers Set in ways Make ‘long lasting’
decisions Are right most of the
time Have invested a lot of
themselves in the old way
Analytical Utilise technology Focussed Flexible Accuracy is not
needed Conceptual Knowledge
gathering Utilise “Team”
vs
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Intuition
Decisions based on intuition are commonly flawed because of bias and missing or misleading information.
From Strategic Investment Decisions. Harnessing opportunities managing risks. L Krantz, A Thomason. FT/Prentice Hall. London.1999.
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Proper analysis
Alternatively, proper analysis may be discouraged because it is seen as – too complex to conduct, – too time-consuming, – too costly or ineffective.
Individuals may prefer to rely on intuition, ‘gut feelings’, to determine their course of action.
From Strategic Investment Decisions. Harnessing opportunities managing risks. L Krantz, A Thomason. FT/Prentice Hall. London.1999.
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Black Box Mentality
Inputs Output??
What decade did your decision makers learn their trade?
What was the current state of technology at that time?
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Advisors
What are they employed for?
How much have they invested in their advice?
How much has the company invested in their advice?
Do they know their job?
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Flicking the switch
How do we get them turned on?
GO
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Spreading the ‘Word’
Assumption: being right will not gain support and buy-in.
Permeation will occur when and where weaknesses allow it.
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Let them adopt it for their needs
Smith & Nephew for example Lead customer Early adoption by a big customer Raised as questions in other business situations
– Not imposed on middle management– Just communicated with examples for discussion
Raised awareness of opinion leaders within S&N Used as part of idea selection
– adoption by scientists / project leaders.
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Key diffusion issues within Smith & Nephew
Broadly accepted need– Justified gut feel projects that other methods throw out.
Key enablers in place to allow adoptions– Forecasting, Portfolio management
Solution not threatening to top management– Presented as a decision support tool for top management
Methodology allowed better representation of key information– Presenters and recipients were more comfortable
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Luehrman PortfolioGRC Project Portfolio
0
1
2
3
4
5
6
7
-2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0
LN(Value/Cost quotient)
Cum
Vol
atili
ty
BUILD
Probably Invest
Consider Carefully
HOLD
NEVER NOW
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When do “Real Options” make a difference? Traditionally
– If Return is >>> Investment “No Brainer”
– If Investment >>> Return “Kill”???
Look for marginal calls, where the decision maker has a vested interest.
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Comparison of Methods
From Vrettos & Steiner.In Vivo May 1998, p27-32
Value
Project Lifetime£0
Option
DTA
DCF
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Pet projects
Tissue Engineering ten years ago? Traditional approaches with negative £ value led
to– “gut feel”– Soft items
Science Ambition Legacies
Real Options can incorporate gut feel especially where it relates to upside £
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Reducing Uncertainty and Expectations
Max
Min
Actual Outcome
NPV
Time
Possible outcomes at review dates
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Managing Uncertainty - after Newton and Pearson
Like
lihoo
d
Return
Project start
Regulatory
Development
End of Research
Project Timeline
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Qualitative and Quantitative
The risk management process requires the integration of qualitative and quantitative analytical support in an iterative cycle of management activities through the whole life of an investment.
The quantitative analysis tests the insights and conclusions developed during the qualitative analysis by producing real dimensions required for most decisions.
From Strategic Investment Decisions. Harnessing opportunities managing risks. L Krantz, A Thomason. FT/Prentice Hall. London.1999.
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Opening up opportunities that may have been dismissed Volatility
– Our volatility is limited by the thoughts of the organisation?
– What if? Should lead to how?
? ££££
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Setting targets and Contingency levels
Expected
Target
0% 40% 60% 80% 100%20%
100%
80%
60%
40%
20%
0%
20% probability of attaining schedule target
Earli
est F
inish
Late
st F
inish
Expe
cted
Fin
ish
Targ
et F
inish
Cum
ulat
ive P
roba
bility
Cumulative Probability
Maximum Cost
Minimum Cost
Expected Cost
Target Cost
20% probability of attaining cost target
Time (years)
Tota
l Cos
t (£)
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Raising targets
How often do you get…– “I can guarantee to deliver that”
Does this lead to rapid growth or maintenance of the status quo?
Commitment or committed?
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Intangible assets Intelligent use of Real Options can lead to a
“valuation” of intangibles such as Knowledge, patents…
Relies on definition of the work and imposing decisions after the acquisition of the intangible.D
ecis
ion
Poin
t
££
££
££
STOP
NOW
FUTURE
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Upside of risky decisions
Given that some of our investments will fail, how do we know our more risk acceptance culture will pay back?
– If we are risk averse, why should we change our nature?
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Our Current Portfolio is low risk.
Current Markets New Markets
Current Products
New Products
Risk comfort line
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Current Markets New Markets
Current Products
New Products
From: Clayton M Christensen, The opportunity and threat of disruptive technologies, 1997
Total Revenues Accumulated by all firms, 1976 -1994
$237
Average per Company $16
Total Revenues Accumulated by all firms, 1976 -1994
$14420
Average per Company $1800
Total Revenues Accumulated by all firms, 1976 -1994
$3056
Average per Company $83
Total Revenues Accumulated by all firms, 1976 -1994
$36050
Average per Company $1500
Total accumulated revenues, 1976 –1994, of all companies employing each entry strategy
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Level of accuracy
If the future is uncertain why do we need to be certain about now?
What are we trying to do?– Justify this piece of work?– So how positive does it need to be?
If the precision improves our thinking on the model of the future it is worthwhile, otherwise…
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SSmin
max
What are we valuing?
C,X,S all in £
XXNO
YESCC
tC = SN(d1) - Xe-rtN(d2)
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Simple software allows easier examination of inputs
Sensitivity Analysis
-0.60 -0.50 -0.40 -0.30 -0.20 -0.10 0.00 0.10 0.20
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Qualitative and Quantitative
“Whenever we are tempted to further refine our scoring of uncertainties, we should ask ourselves if we are attempting to use qualitative analysis to produce quantitative measures.”
From Strategic Investment Decisions. Harnessing opportunities managing risks. L Krantz, A Thomason. FT/Prentice Hall. London.1999.
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Real world scenarios into real options calculations Five data points Have an NPV (S) Have Cost (X) Know T-t R is often given Sigma – guess or use Pert methods Quick Black - Scholes, change variables and
understand what happens when the calculation goes belly up off we go.
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Pert Method of Forecasting
EV = (a + 4m + b)/6 s.d = (b-a)/6
a = pessimistic b = optimistic m = most likely
Needs experts! Can use Delphi approach
= s.d/EV
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Management
Successful investments are not delivered by analysis alone and management of both objectives and risks must continue throughout the whole life of an investment.
From Strategic Investment Decisions. Harnessing opportunities managing risks. L Krantz, A Thomason. FT/Prentice Hall. London.1999.
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Speculation and Investment
“Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort, which should be successful, to prevent a lot of money becoming little.”– Fred Schwed – FT 22/11/99