Real Options in Project Management and the $4 You’ll Never See Again
Choices – we all make hundreds each day. Some of them are simple; what should I have for breakfast? Some require more reflection; should I hire this person that I just interviewed? And others are made only after careful investigation, research, and analysis; should I buy off-the-shelf software or develop a custom solution?
My question to you doesn’t involve the decisions you have made. Rather, I’d like you to consider how you decided WHEN to make the decision? Maybe more importantly, how you arrived at WHAT to decide (and what to re-visit in the future)?
Projects are full of decisions; Buy vs. Build, Expand or Contract, Agile vs. Waterfall, etc.? Too often, politics, policy, business relations, and fear cause organizations to make these types of decisions at the wrong time. Often they make what seems to be the “right” decision AT that point in time, but still manage to make the wrong decision for the long run. There is an entire field of finance related to assessing the value of an OPPORTUNITY to make decisions. The field is called ‘real options’, and there is a lot of information out there on it. Much of the information centers on the idea of applying financial options theories to real life decisions to better evaluate opportunities that include future decisions.
You’ve probably heard of financial options. Once a product only for professional investors, they are now widely available on popular online platforms targeted to individual investors like eTrade. The simplest options are a ‘call’ and a ‘put’. A call is the option (but not the obligation) to buy an asset at some point in the future for an agreed upon price. For example, if a share of GE common stock is currently trading at $23.75, you might be able to buy a call option that would give the buyer the right to purchase the shares for $25.00 (strike price) any time between now and July 15th (expiration). A put option would give you the right (but not the obligation) to sell the stock (or other asset). Options also have terms. In some cases, you might be able to exercise the option at any time up until the expiration date (American Option). In others, you are only able to exercise at the contracts’ expiration (European Option). For this privilege you would pay a small price, perhaps $0.50 per share. If the price should appreciate between now and July 15th, you have given yourself the opportunity to buy the stock for less than its price. If not, you can simply decide not to exercise your option. In practice, most commonly traded stocks and funds have an options market that would give you a variety of choices, each with a different strike price, expiration date, and terms. Each of these specifics has a dramatic effect on the price of the option. Also, options can have a wide variety of underlying assets. Commodities (oil, gas, grain, pork bellies), corporate and sovereign debt (credit-default swaps are an example), or the weather (rainfall in a particular zip code over the growing season) can all be used to create options.
I won’t go any further in explaining the mechanics of financial options because: A) You’re probably not interested in taking investment advice from me, and B) I’m probably not qualified to give it. However, I will share with you a few accepted truths about options that are important for you to know.
- All future options have SOME value, though not necessarily enough to justify their price.
- Option prices will increase as the uncertainty of the value of the underlying assets increases.
Both hold true for real options as well. I’ll give you a quick example before moving away from options theory and into Project Management reality.
Suppose I were to offer you on April 1st, the option to buy tickets to the first home game for the Cubs in the 2013 World Series in Kenway’s excellent seats near home plate for face value (say it’s $150). How much would you pay for such an option? Well, that decision would rest on two key factors. First, how valuable would such an item be? To determine this, you’d want to know what the market price of a ticket would be at the time of the game. Let’s assume we can fairly estimate that such a ticket would cost $2,000 on a site like StubHub. Next, you’d need to estimate the uncertainty of this value. As of April 1st, the season will have only just started, so the Cubs record won’t be very meaningful. Let’s say that you think there’s a 2% chance of the Cubs reaching the World Series. If so, a fair price might be just under $4. 2% of the time you’ll get the ticket, a $2,000 value, for $150 (plus the $4 option price), and 98% of the time you’ll lose $4. But how would the value change if you had the same option on September 1st, when the season is almost complete? By then, you’ll be much more certain of the Cubs World Series chances (there’s always next year). How much might the same option be worth the night before a deciding 7th game in the NLCS that included the Cubs?
What Does This Mean to My Project?
Consider the application for a project with its many decisions. Recall those two key concepts of options pricing:
- All future options have SOME value, though not necessarily enough to justify their price.
- Option prices will increase as the uncertainty of the value of the underlying assets increase.
Some projects have more uncertainty than others. In most cases, complexity and uncertainty go hand in hand. The more complex the project, the more uncertain the benefits and costs of the project will be. According to #1 above, this makes options on such a project MORE valuable. Translation – if your project has a lot of unknowns or complexities, don’t try to make every decision up front. Make the best decisions that you can along the way, but don’t give away your choices any earlier than necessary.
In a systems development world, the underlying value of the security isn’t a stock price or the value of some index; it’s the value of the project in question. When you complete an application deployment, that system has some value for your organization. Developing that solution had some cost to your organization. Most of the time, we can only make educated guesses as to what that value will be prior to its deployment. The trick with systems development is that your costs are borne almost entirely at the beginning of the project, and the benefits are realized almost entirely after the costs are sunk.
The point of #2 above is that you should always consider the value of retaining the right or ability to make a future decision even if that decision is unlikely to be different from the decision you would make today. This does NOT mean that you should postpone making decisions indefinitely. Waiting to decide comes with costs as well as benefits. At some point, those costs will be greater than the benefit of waiting.
So, how can I derive value from waiting to decide?
Projects require many decisions to be made. Each choice impacts that final result in some way. Too often, I see clients make many decisions early in a project either because they feel a need for a complete end-to-end plan (and resist any change to the plan) or because their organizational approval process requires some detailed data. Most often, this occurs when a budget must present sufficient ROI projected in advance of the project funding being allocated. These are logical and necessary steps. Nevertheless, a budget is a plan, and plans require flexibility to accommodate changes in the current situation. As managers, we should not let a budget plan constrain our decision making. If an opportunity comes along to change the plan, it should be considered on its merits, even though that may mean changing a budget the boss has already approved or moving a deadline that has the potential to negatively impact cost, quality, or scope.
For example, I recently worked with a client that was rolling out a new software application to over 200 locations. We anticipated that each location would benefit financially as the application would result in increased revenue per customer. While the budget and project justification had taken a stab at the magnitude of the revenue gains, we really did not know how big the impact would be. Further, we knew that there were many operational issues to work out as the application was replacing a process that was mostly on paper.
Rather than rolling out quickly, we strategically selected a few locations for a pilot program. From that pilot, we identified several process and system changes that would smooth the transition for future locations and slightly enhance the return on investment. This greatly reduced the risk of implementing a large change and increased the return on investment (though it did push the schedule out a bit). Before the pilot sites, we had a lot of unknowns. After the pilot, many of those unknowns became known, and many others went from ‘highly uncertain’ to ‘predictable within a range’.
Don’t be afraid to keep your options open. When faced with a lot of unknowns, identify ways that you can create your own “real option” to experiment, change course, or refine the plan. In the end, doing so will leave you with more successful projects and less risk.