erisk interview 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 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
 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 b 2 b business models have questions marks hanging over them , and many
b 2 c 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
erisk interview
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 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
 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 b 2 b business models have questions marks hanging over them , and many
b 2 c 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