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Options are No Longer Optional

As this note is published, the LEF study tour bus will be navigating the hallowed grounds of Silicon Valley and Seattle on our latest study tour. This tour is themed ‘Applying Machine Intelligence’. The next, in September, is centred on ‘Re-architecting for a Smarter World’, with a big focus on the internet of things. I really enjoyed the last study tour (my first), and I am excited to participate in this next one. A group of CIOs and other digital leaders travelling together to visit the digerati (Amazon, Google, Microsoft, Facebook, etc.), startups from the portfolios of Andreesen Horowitz and Madrona Venture Group, and other selected digital innovators. Discussing digital innovations with them and the group. Dreaming about the possibilities, and discussing the realities of implementing them in our current contexts. What’s not to love?

Options are No Longer Optional

Many investments are a good idea, but it is not possible to add up revenues and costs over time.

Well, there is a cost involved, and an investment of time. How do you justify that time? We have seen several inspiring stories, like how Frank Luijckx was strongly influenced by one of our study tours when he started his machine intelligence-based business 4th-IR. And more generally, how CIOs from different industries learned about new technologies, made connections, and helped each other. But could you do a Net Present Value calculation and prove mathematically that there is a return on investment (ROI) for attending? Almost certainly not.

Many investments are like this. They are almost certainly a good idea, but it is not possible to add up revenues and costs over time, and come to a figure for the profit. Why? Largely because of uncertainty. And we are not talking about uncertainty of the order of +/- 10 percent. We are likely to be asking whether it will result in us finding a multi-million-dollar investment to make, or two, or three, or none at all. A study tour might not result in anything immediate – or it might result in a massive cost saving through meeting a vendor we didn’t know before and who offers us a much more cost-efficient cloud-based solution; or in a relationship that involves us learning about and avoiding the ‘gotchas’ associated with a particular technology.

To deal with really major uncertainties, we need to look to the language of options.

We can deal with +/- 10 percent-type uncertainties with scenario planning – what if the project overruns a bit, or what if customer uptake is a bit faster or slower? But to deal with really major uncertainties, we need to look to the language of options.

In the world of financial services, options are well understood. An option is the right, but not the obligation, to do something1. For example, at the time of writing, the price of a bitcoin is just over $1,000. If I know there is a chance I am going to get paid 5,000 bitcoins in 3 months’ time, I might like to reduce the risk related to the bitcoin/$ exchange rate, by buying an option to sell 5,000 bitcoins at an exchange rate of $1,000. If the bitcoin exchange rate stays the same or moves in my favour, I don’t have to exercise the option, but if the movement is unfavourable, I can. The option to do that might cost me $100,000. The maths behind pricing these options is quite complicated, and uses methods such as Black-Scholes, binomial tree and Monte-Carlo simulation. (Those interested in knowing more could pick up a book on option pricing.)

The important thing to understand is that options are everywhere, embedded in assets, transactions and relationships:

  • When we buy cloud services that can scale up and down based on our needs, we are, in effect, buying an option on those cloud services.
  • When we invest in a new piece of software/services, we are, in effect, buying the capabilities of the initial service, plus the option to add on other services and future services later.
  • When we invest in big data, we are really investing in the right to invest in other initiatives guided by the insight that data brings.
  • When we spend time and/or money learning about a vendor, technology or any other topic, we are investing in an option to use that knowledge later. Taking a university degree is, in effect, a huge options investment. Research and Development organizations, hackdays and experience labs are also options investments.
  • When we buy our partner a gift, we are in effect … actually let’s not go there!

So, when we invest in anything, we are investing in predictable value implications (best measured by a cashflow measure, like Net Present Value – NPV), and we are also investing in options for future investment (best measured as options). Hence, when we try to value any investment, if we only look at the NPV component, we are undervaluing that investment. (Because options are a right, but not an obligation, options never have a negative value outcome2.) For example, investing in a new internet of things (IoT) factory automation system to increase productivity may look like it has a negative NPV given current market conditions, but when we factor in the option related to selling more if market prices change, it may be an investment worth making.

The real rub comes when the NPV component is small or non-existent, and the option component is the main thing. For example, when you build a platform for others to trade on, there is usually too much uncertainty to use conventional cashflow value measurement, but option valuation is perfect, since it estimates a probability distribution of transactions of different size and value to you.

In a world with high levels of VUCA, the option components of almost all investments get relatively bigger.

In a world with high levels of VUCA (volatility, uncertainty, complexity and ambiguity), the option components of almost all investments get relatively bigger. So, in the factory automation example above, the more volatile market conditions are, the higher the option value.

In our note on anti-fragility to be published shortly, Bill Murray and I will talk about using options thinking in making our businesses thrive in uncertain times; but more generally, it behoves senior leaders and especially digital leaders to familiarize themselves with the ideas of real options. There is a discipline for measuring the options component, called Real Options Valuation (ROV3), but even if it is too much (for now) to use options in a mathematical way to calculate financial value estimates, it is at least worth identifying, acknowledging and discussing the options embedded in the investments you are considering and making.

Ironically, we at LEF would argue that embedding options thinking in your valuation, decision-making and governance mechanisms is not optional for 21st Century Organizations. Options thinking is now mandatory.


 

1. Contrast this with futures, which represent an obligation, e.g. the obligation to sell bitcoins at $1,000.

2. Just to be clear: an option never has a negative value outcome, but it may be value-destroying to buy an option, depending on the price. For example, an option to buy some shares may be worth $5. If you pay $10 for it, that is a value-destroying decision (-$5), but the option is not worth a negative value – it is worth $5.

3. The term ‘real’ here is used to differentiate the right to invest in real things (like factories) from the right to buy and sell financial instruments (like currencies and company shares).

COMMENTS

Eric Makarein 23.20PM 04 Apr 2017

I like this view and fully agree but needs to be looked at in a slightly broader context Options - Risks - Change When linking the three you expose the the broader context of how we live, how we operate, how we get on in life, how a business runs. Think I could write a blog or paper on this.

Dave Aron 08.28AM 05 Apr 2017

Nice point Erik. Bill Murray and I will publish a note within the next week or so on anti-fragility, which I believe encompasses the scope you mention. Please let us know when you have written your blog too - interested to read it.

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