Why building Options on different future Scenarios reduces your Risk
10 min read.
- In a volatile world, options gain in value and help reduce the risks of portfolios.
- It turns out that options are not just financial instruments: innovative projects betting on uncertain futures can also be modelized as options in the real world.
- Thanks to Foresight and Game Theory, you can build diversified innovation portfolios within your company that will give a clear, optimistic direction to your teams, while seducing your investors and prove your capacity to create future value.
In a world that is increasingly uncertain, companies tend to be more cautious and reduce their investments. Likewise, a lot of innovation projects fail because they were betting on a world that never happened, creating disappointment for the teams that were building them, or even doubt in the management’s strategic vision.
But betting on multiple futures and launching new projects in a step-by-step mode actually reduces your overall risk as a company, even if it means giving up on a good deal of them along the road. Why?
Let us introduce you to Real Options, Foresight and Game Theory. Or how a diversified innovation portfolio reduces your risk and maximizes your chance of success.
I / Common sense advises not to invest and innovate in times of uncertainty – it’s just too risky
The economic environment is increasingly uncertain, translating into increased market volatility1,2,3 The concept dedicated to this phenomenon is VUCA (Volatile, Uncertain, Complex, Ambiguous).
Uncertainty increases risk and volatility (price variance of assets) and reduces the outcome of investment projects, notably when analyzed with the NPV method4,5.
Yet, in financial portfolios, a specific contract gains value in face of uncertainty: the option contract.
Options can be used to leverage directional plays with less potential loss than owning the outright stock position. This is because long options can only lose a maximum of the premium paid for the option but have potentially unlimited profit potential.
II / Now – What if these options also existed in the real world?
A Real Option is a capability you create to obtain a competitive advantage in case a future event happens.
A Real Option is:
- Related to a specific event in the future.
- Creates a competitive advantage: patent, learning acquired, rare resources captured, brand image, first mover advantage…
- Allows to expand or to control the production of a given good or service.
Real Options are a precursor of the agile methodology, encouraging a portfolio approach involving many low-cost, staged investment bets.6 Research has shown that Real Options Valuation can better explain market valuations and many investment decisions than traditional DCF-based approaches in diverse areas.7
Many companies’ valuations are complicated to compute for traditional investors, especially for innovative companies. DCF-based approaches don’t explain their future profits, and multiple methods have simply no companies to compare them to.
Tesla is a good example, and as Morgan Stanley analyst Adam Jonas puts it:
‘Out of our $540 price target, $254 is attributed to the core auto manufacturing business, $154 to the network-services business opportunity, $58 to the potential of becoming a supplier of batteries and powertrain to third parties, $38 to the mobility and ride-sharing business opportunity and $25 to the insurance and energy business.‘8
More than half of Tesla’s valuation, according to this analyst, comes from Real Options the company has taken on future scenarios.
To create a capability, you can either:
- Build, and create the capability in-house.
- Partner, and create the capability with relevant partners or ecosystem.
- Buy the capability by taking a majority stake in a company that could be scaled later on.
- Invest and take a minority stake in a company that could later be useful regarding the future event considered.
Strategic Foresight allows to imagine different futures and create the right options to prepare for them9.
But to imagine different possible futures related to your industry and the rest of the world is not enough; you also have to imagine the reactions the different actors of your ecosystem will pursue10:
A real option in itself is very risky – just like a financial option. Creating capabilities for multiple hypothetic futures seems foolish, as they each have a high chance to fail, even if they could bring high rewards in case the predicted future happens.
But just like in finance, while an option is very risky considered for itself, it actually helps balance the overall risk of your asset portfolio and is usually considered a way to reduce your risk as an investor11.
III / Real Options are the best way to balance the overall risk of your innovation portfolio and maximize your chance of success12,13.
Building such innovation portfolios will provide your company with a strong advantage in the long-term and also seduce investors in the short-term. Enhancing the value of your company, whether you are listed or not, will turn your strategy into a self-fulling prophecy, as you will now have access to cheaper capital to invest in these projects.
This alignment of your employees is also turning the strategy into a self-fulling prophecy, as engaged teams is the number one factor to your success as a company.
Just as importantly, it will give a clear vision to your teams on why the management is engaging in different directions, and why it’s ok to fail sometimes – it was just an option you took on a future that never happened.
Do not hesitate to contact us at Kéa Tilt to know more about our methodology, and how we could turn it into a reality together!
Georges Raybaud for Kéa Tilt
- Forbes 09.20.2021 A Volatile Market pressures global markets
- Schwab 09.28.2021 Market Volatilty
- Amundi 05.04.2021 The end of Great Moderation
- Lin, Y.; Dong, D.;Wang, J. The Negative Impact of Uncertainty on R&D Investment 2021
- WorldBank 12.21.2020 Foreign investors wait on the sidelines as uncertainty looms
- Trigeorgis, 1996
- Moel and Tufano, 2002
- 12.14.2020 ‘Morgan Stanley and JPMorgan Analysts Differ on Overvalued Tesla Stock’
- Inspired by Philippe Durance, Joseph Coates and Michel Godet, Strategic Foresight, 2010
- 04.17.2017 – Han T. J. Smit,Lenos Trigeorgis – Strategic NPV: Real Options and Strategic Games under Different Information Structures
- Investopedia.com Options
- 09.20.2006 Han T. J. Smit, Lenos Trigeorgis – Strategic planning: valuing and managing portfolios of real options
- Georges Raybaud for KéaTilt, 2021