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Management article
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Reference no. 98506
Authors: Timothy Luehrman
Published by: Harvard Business Publishing
Published in: "Harvard Business Review", 1998

Abstract

In this article, Timothy A. Luehrman, professor of finance at Thunderbird, The American Graduate School of International Management, explores how option pricing can be used to improve decision making about the sequence and timing of a portfolio of strategic investments. In financial terms, a business strategy is much more like a series of options than like a single projected cash flow. Executing a strategy almost always involves making a sequence of major decisions. Some actions are taken immediately while others are deliberately deferred so that managers can optimize their choices as circumstances evolve. While executives readily grasp the analogy between strategy and real options, until recently the mechanics of option pricing were so complex that few companies found this method practical to use when formulating strategy. But advances in both computing power and our understanding of option pricing over the last 20 years now make it feasible to apply real-options thinking to strategic decision making. To analyze a strategy as a portfolio of related real options, this article exploits a framework presented by the author in "Investment Opportunities as Real Options: Getting Started on the Numbers" (HBR July/August 1998). That article explained how to get from discounted-cash-flow value to option value for a typical project; in other words, it was about reaching a number. This article extends that framework, exploring how, once you''ve worked out the numbers, you can use option pricing to improve decision making about the sequence and timing of a portfolio of strategic investments. The author shows executives how to plot their strategies in two-dimensional "option space," giving them a way to "draw" a strategy in terms that are neither wholly strategic nor wholly financial, but some of both. Such pictures inject financial discipline and new insight into how a company''s future opportunities can be actively cultivated and harvested.

About

Abstract

In this article, Timothy A. Luehrman, professor of finance at Thunderbird, The American Graduate School of International Management, explores how option pricing can be used to improve decision making about the sequence and timing of a portfolio of strategic investments. In financial terms, a business strategy is much more like a series of options than like a single projected cash flow. Executing a strategy almost always involves making a sequence of major decisions. Some actions are taken immediately while others are deliberately deferred so that managers can optimize their choices as circumstances evolve. While executives readily grasp the analogy between strategy and real options, until recently the mechanics of option pricing were so complex that few companies found this method practical to use when formulating strategy. But advances in both computing power and our understanding of option pricing over the last 20 years now make it feasible to apply real-options thinking to strategic decision making. To analyze a strategy as a portfolio of related real options, this article exploits a framework presented by the author in "Investment Opportunities as Real Options: Getting Started on the Numbers" (HBR July/August 1998). That article explained how to get from discounted-cash-flow value to option value for a typical project; in other words, it was about reaching a number. This article extends that framework, exploring how, once you''ve worked out the numbers, you can use option pricing to improve decision making about the sequence and timing of a portfolio of strategic investments. The author shows executives how to plot their strategies in two-dimensional "option space," giving them a way to "draw" a strategy in terms that are neither wholly strategic nor wholly financial, but some of both. Such pictures inject financial discipline and new insight into how a company''s future opportunities can be actively cultivated and harvested.

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