U n ce r t a in t y :
Th e N e w Ru le s for St r a t e gy
Mart ha Am ram
Nalin Kulat ilaka1
Mar ch, 1999
prepared for t he Jour nal of Business St r at egy
Most grow t h opport unit ies share a com m on feat ure: uncert aint y. I n t oday’s
econom y, st rat egic invest m ent s m ust be m ade w it hout a pinpoint forecast of t he
fut ur e. At fir st t his seem s like a quest ion of bad input s – “ j ust go find t he dat a! ” But
it ’s not .
Managing in t he face of uncer t aint y is differ ent . I t r equir es t w o im por t ant
skills: t he abilit y t o ident ify valuable oppor t unit ies and t he abilit y t o adapt t o
m arket place changes. Managers oft en int uit e a connect ion bet w een st r at egic
invest m ent s and value, even w hen t her e ar e no im m ediat e cashflow s. How m any
t im es have you ignored a quant it at ive analysis, j ust ifying a proj ect on “ st rat egic
grounds” ? We need t ools and m et hodologies t hat m ake t his link visible. And,
m anagers m ust be able t o capit alize on good out com es of uncert aint y, t hey m ust be
adapt ive and flexible. I s t here a proj ect in your com pany t hat w ent exact ly as
planned? Or w ere t he best proj ect s one t hat adapt ed t o changing condit ions? We
need a capabilit y – t im ely infor m at ion, decision m aking t ools and or ganizat ional
support – for guiding proj ect s t hrough uncert ain environm ent s.
Tradit ional valuat ion and st rat egic planning t ools don’t w ork very w ell in a
m anager s have t o r espond t o unfolding event s. We’ve writ t en a book about a new
approach, real opt ions t hat “sees” these opport unit ies and values t hem , creat ing an
int egrat ed st rat egy and valuat ion fram ew ork.
The r eal opt ions appr oach has it s or igins in finance, st ar t ing w it h t he Nobel
Prize w inning w ork on valuing financial opt ion cont ract s. Early on, academ ics saw
how opt ion pricing m odels could be applied t o a variet y of non- financial or real
asset s. And t hey saw t hat t he real opt ions approach could be a bridge bet w een
finance and st rat egy – aft er all bot h disciplines at t em pt t o obt ain t he highest possible
ret urn on risky asset s.
The real opt ions approach has a host of im m ediat e applicat ions. We’d like t o
int r oduce som e of t he key ideas by t hinking t hr ough a hot t opic: t he value of
I nt er net com panies. Then w e’ll give you exam ples fr om com panies in t hr ee ot her
indust ries and close w it h t he new rules for st rat et gy under uncert aint y – insight s
w e’ve developed from w orking w it h com panies using t he real opt ions approach.
Va lu in g t h e N e w Gr ow t h Oppor t u n it ie s
I nt er net com panies t ypify t he cur r ent valuat ion dilem m a, but t he sam e issues
are present in grow t h opport unit ies t hroughout high and low - t ech indust ries. Why
ar e w e having such a har d t im e valuing I nt er net com panies? Because t he t r adit ional
valuat ion t ools used by Wall St r eet ar e fr om anot her er a – t hey are based on
account ing syst em s for m anufact uring com panies in st able indust ries and are
focused on current and near- t erm cashflow . The valuat ion problem for m odern
gr ow t h oppor t unit ies, I nt er net com panies included, is hugely differ ent : How do you
value an im m at ure, fast grow ing com pany in a young indust ry w it h rapidly changing
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boundaries and business m odels? Let ’s w alk t hrough how t he real opt ions approach
can be used t o answ er t his quest ion.
The value of an I nt ernet com pany depends on how it w ill deal w it h four key
feat ur es of t he I nt er net envir onm ent : enor m ous uncer t aint y; a com pet it ive
landscape paced by t echnology innovat ion; a need t o rapidly adapt t o changing
condit ions; and t he cost s of sear ching for a pr ofit able business m odel. I n t he
I nt er net w or ld, t oday’s successful st rat egy does not guarant ee fut ure profit s; oft en
t he com pany m ust “ m orph” to t he next t hing. None of t hese feat ur es fit t he
t radit ional cashflow - based approach.
We’ve developed a t w o- phased approach t o apply real opt ions t hinking t o
I nt ernet com pany valuat ion. The first phase st art s at t he back. What is t he m at ure
com pany business m odel and w hat is it s value? Wall St r eet ’s t ools w or k fair ly w ell
for m at ure com panies because t hey have a fixed and know n st rat egy. But t oo oft en
Wall St r eet ’s analysis also st ops at t he back, as analyst s gloss over t he challenge of
t he j our ney t o t he end gam e - - neglect ing w hat it t akes t o get t her e.
The second phase exam ines t he opt ions an I nt ernet com pany m ust acquire
and execut e t o get t o t he end gam e. We argue t hat m ost com pany invest m ent s in
t he volat ile I nt er net w or ld ar e opt ions – business invest m ent s t hat cr eat e t he
opport unit y t o m ake decisions in t he fut ure, aft er event s unfold. For exam ple, a w eb
sit e cr eat es an opt ion for fur t her invest m ent , t hat of building and t est ing an
e-com m er ce connect ion t o cust om er s. A successful I nt er net e-com panies r ecognizes
t hat r eaching m at ur it y r equir es it t o invest in a sequence of opt ions. The final set of
opt ions leads t o m at ure com pany st at us and cashflow . The next one back creat es
t he oppor t unit y t o invest in t he final set of opt ions, t he second one back cr eat es t he
opport unit y t o invest and so on. Bet w een now and m at urit y, t he com pany’s value is
As our sidebar show s, t hese opt ions can be quant ified. I n fact , t here is
enorm ous rigor behind our approach, as st rat egic opt ions can be valued using t he
arsenal of t ools developed for financial opt ions. Using t he opt ions approach allow s
com pany valuat ions t o sensibly r eflect t he fut ur e, despit e t he lack of cur r ent or near
-t erm cashflow .
We t hink Wall St r eet and r et ail invest or s have been t r ying t o st r et ch
cashflow - based approaches t o valuat ion t oo far, neglect ing t o t hink t hrough w hat it
is r equir ed for an I nt er net com pany t o r each m at ur it y. I t ’s going t o t ake flexibilit y
and fur t her invest m ent s. I t t akes a w illingness t o adapt and abilit y t o r epeat edly
raise capit al. Not all com panies w ill survive, and t oday’s valuat ions should be
discount ed t o reflect t he t rue odds. Right now , m any invest ors are relying on
cashflow - based m odels t o benchm ark value ( w hich can’t work) , and valuat ions are
ranging w idely. The bet t er- anchored opt ions- based approach narrow s t he range of
r easonable valuat ions.
Valuing an I nt er net com pany pr esent s m any of t he sam e issues as valuing
corporat e grow t h opport unit ies, part icularly in how st rat egy and valuat ion are
int er t w ined. The r eal opt ions appr oach helps t o ident ify t he m ost valuable st r at egies
for a w orld of uncert aint y.
Th e N e w St r a t e gie s in Act ion
Let ’s look at t hree applicat ions of t he real opt ions approach t o valuat ion and
st rat egy. These applicat ions span a w ide range and illust rat e how t he real opt ions
appr oach is int egr at es a var iet y of issues int o a single st r at egic valuat ion fr am ew or k.
Our fir st applicat ion is invest m ent s in infor m at ion t echnology ( I T) . For m ost
in fast - m oving m arket s. For exam ple, suppose t he chief inform at ion officer m ust
decide bet w een a server t hat fit s t oday’s needs plus reasonable growt h or prem ium
-priced server t hat w ill accom m odat e ult ra- fast grow t h. I s t he great er expense
j ust ified w hen ult ra- fast grow t h m ay or m ay not happen? The real opt ions approach
recognizes t hat t he prem ium - priced server creat es an opt ion for ult ra- fast grow t h,
and helps t he st r at egist link ser ver feat ur es t o t he value and likelihood of st r at egic
obj ect ives. The ser ver should be pur chased only if t he value of t he opt ion it cr eat es
exceeds t he price prem ium .
Our second applicat ion is oil explor at ion. Consider t he case of seism ic
explorat ion, in w hich sound w aves are used t o im prove t he est im at e of how m uch oil
is in t he gr ound. An explor at ion invest m ent w ill nar r ow t he r ange of uncer t aint y
So t he key quest ion for t he pet r oleum engineer is w het her t he value of t he im pr oved
infor m at ion exceeds t he explor at ion cost . At som e point , t her e is no point in
spending t o reduce uncert aint y and t he reserve is eit her developed or abandoned.
The r eal opt ions appr oach int egr at es t he geological uncer t aint y w it h oil pr ice
uncer t aint y so t hat explor at ion decisions ar e in line w it h valuat ions in t he oil
m arket s.
The t hir d applicat ion is int ellect ual pr oper t y. For an incr easing num ber of
com panies, an im port ant source of revenue com es from licensing and selling
int ellect ual pr oper t y. The t er m s and condit ions on t hese licenses can be com plex,
including paym ent s for perform ance, royalt ies, lim it at ions on use and so on. For
exam ple, one com pany m ay offer t o reduce t he upfront fee required from $4 m illion
t o $2 m illion if t he r oyalt y r at e is incr eased fr om 1% t o 2% w it h a floor of 50 cent s
per unit . The real opt ions approach can be used t o quant ify t he value of t he t w o
pr oposals, including t he floor . Tr adit ional valuat ion t ools cannot cor r ect ly value
floors and caps, so only t he real opt ions approach can keep all t he alt ernat ives on an
Th e N e w Ru le s
Many st rat egist s are facing t he kinds of issues w e’ve been discussing. I n a
fast - m oving w orld of uncert aint y, m anagers m ust be ready t o respond. Here is a
st ar t ing point , 10 r ules for finding t he opt ions in your st r at egic invest m ent s.
1/ Make no assum pt ions: What is your m arket ?
Technology and der egulat ion ar e r apidly blur r ing convent ional indust r y definit ions.
Ret hink your m arket boundaries and com pet it ors t hrough t oday’s cust om er - cent r ic
lens. I nclude sour ces of uncer t aint y and how indust r y player s w ill r espond.
2/ You alr eady have som e answ er s: Use t he insight s fr om dur able econom ics
A good part of t he New Econom y can be w ell underst ood using durable econom ic
pr inciples – concept s and fram ew orks t hat are w ell know n t o econom ist s, but oft en
skipped over in Econ101. Car l Shapiro and Hal Varian have w rit t en in a book t hat
deft ly m akes t his point . As t he aut hor s st at e “ Technology changes. Econom ic law s
do not .”2
3/ I dent ify your opt ions
Gr eat er uncer t aint y cr eat es t he need for gr eat er flexibilit y. Wher e ar e t he opt ions
for fut ur e flexibilit y in your cur r ent pr oj ect s? For exam ple, your plant expansion
com es w it h an opt ion t o w ait – you can st art it now or lat er. Your plant t hat is
current ly running has an opt ion t o shut dow n. ( Rem em ber – t he opt ion t o shut dow n
w ill have som e value even w hen it is not likely t o be used! ) Because t r adit ional
quant it at ive analyses ignore t hese opt ions, you can add t heir value t o a discount ed
4/ Nur t ur e your opt ions
Not hing is fr ee, including t he opt ions you j ust ident ified. What w ill it t ake t o keep
t hese alive as viable invest m ent oppor t unit ies? And som et im es, t he value of t he
opt ion is not w ort h t he it s cost . For exam ple, cont inuing an R&D proj ect creat es t he
opt ion t o t ur n it int o a com m er cial pr oduct . You don’t know if you w ill, but you
m ight . I n som e cases, t he prom ise ( value of t he business opport unit y and likelihood
you’ll cont inue) m akes t he opt ion t o cont inue valuable, in ot her cases you ar e bet t er
off canceling t he pr oj ect . And w e’ve got som e bad new s: Tradit ional t ools, such as
discount ed cash flow , com plet ely m iss t he value of r isky, long- t er m pr oj ect s such as
R&D. Ther e’s no easy fix, but because t he st andard approach alw ays under values
R&D- t ype act ivit ies, your com pany m ay be under - invest ing in new pr oduct s.
5/ Get r eady for flexibilit y
Can you really cancel a proj ect in your com pany? Can you m ake t his decision
obj ect ively? Can you m ake it in t im e t o lim it losses? Flexibilit y cut s bot h w ays – it
capt ures upside pot ent ial and saves you from sinkholes. But only if you are ready t o
act . Oft en w e hear corporat e st aff essent ially saying: “ I see t he opt ion, and t he
course of act ion, but m y boss is such a lunkhead; she’s paralyzed.” The ideas w e’ve
present ed w ill rem ain rat her academ ic if your organizat ion is not ready. As you
ident ify an opt ion, you can help t o r ealize it s value by ident ifying t he r ight
decisionm akers, giving t hem t he appropriat e incent ives and m aking sure t hey get
t he r ight infor m at ion.
6/ I t ’s not your choice: t he pace of decisionm aking
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How oft en does your com pany review it s st rat egic proj ect s? What prom pt s a
decision t o be m ade? To capt ure t he value of opport unit ies t o respond t o unfolding
event s, t he pace of decisionm aking and proj ect review m ust be in st ep w it h ext ernal
event s. I n t he food pr ocessing, it m ay be necessar y t o r eview use of t he t em por ar y
shut dow n opt ion on a seasonal basis. I n t he m ovie indust r y, dist r ibut ion and
advert ising st rat egies are review ed each w eek, based on t he w eekend’s box office
receipt s. Now t hat t he aut o indust ry is building significant elect ronic feat ures int o
our car s and m eet ing cust om er s over t he I nt er net , w ill t heir pace of decisionm aking
also need t o change? Annual and quar t er ly st r at egic planning r eview s have t heir
place, but t hey cannot drive decisionm aking w it hout giving up subst ant ial value from
t he t im ing com ponent of m any corporat e opt ions.
7/ Cr eat e opt ions
On t he first pass of an invest m ent review , you can add significant value over
convent ional valuat ion appr oaches by ident ifying t he opt ions. On t he second pass,
you can get a sim ilar st ep up in value by creat ing opt ions. For exam ple, creat e t he
opt ion t o change course, re- focus or even abandon m idw ay t hrough a proj ect . One
New Econom y fir m , Viant , has t aken t his concept a st ep furt her. They break dow n
t heir e- com m erce/ e- com pany im plem ent at ion proj ect s for client s int o 90- day
m odules. This r educes t he im plem ent at ion r isk, but m or e im por t ant ly, Viant is
cr eat ing valuable opt ions for t heir client s. The 90- day m odule cr eat es a focus on
learning from w hat has been done and on responding t o m arket and t echnology
event s - - and t he opt ion t o m ake new decisions. Viant w ins because it ’s easier t o
sell t he m or e valuable, flexible pr ocess. The cust om er w ins because t hey'r e get t ing
a m ore valuable proj ect , one t hat includes opt ions. And of course Viant needs t o
8/ Too m any opt ions, t oo few r esour ces: You can’t do it all
Opt ions change t he m eaning of focus. I dent ifying, nur t ur ing, and creat ing
opt ions t akes subst ant ial t im e and ener gy. Meanw hile your indust r y pace is picking
up, t echnology is becom ing m or e com plex and it ’s har d t o hir e t he key people in
your core business area. Regis McKenna said it 1985, and it ’s st ill t r ue t oday: “ As
t echnologies advance and becom e int ert w ined w it h one anot her, no single com pany
has t he full r ange of skills and exper t ise t o br ing pr oduct s t o m ar ket in a t im ely and
cost - effect ive w ay.”3 Hence you need t o focus on your cor e capabilit ies, and all t he
associat ed opt ions, part nering for t he rest . Have you not iced t hat even Microsoft
doesn’t do it all?
9/ Cont ract ing t ransparency: Discipline is here
Ever ybody’s cont ract ing. Elect ric pow er com panies now m eet dem and by
generat ing pow er or cont ract ing for pow er. Telecom m inut es and bandw idt h is now
bought and sold on four different exchanges. Biot ech com panies rout inely develop
pr oduct s w it h t he int ended st r at egy of licensing m ar ket ing r ight s t o a lar ge
pharm aceut ical com pany. Ot her biot echs, such as The Medicines Com pany, acquire
drugs in lat e- st age developm ent t hrough a license and t hen com plet e t he product .
( Act ually, t hey don’t even com plet e t he product t hem selves, t hey part ner – t hr ough
cont ract s – w it h ot her com panies.)
Ther e ar e t w o cr it ical point s of discipline in t hese cont r act s. Fir st , physical
and cont ract ual asset s m ust line up. Elect ric pow er generat ion asset s, for exam ple,
are no m ore valuable t han t he cont ract s w rit t en on t hem . And cont ract s for pow er
can’t be at prices higher t han self- generat ion. Second, cont ract s and licenses w rit t en
division public, one financial m ar ket analyst com m ent ed: “ MI Ps is going t o live and
die by it s licenses.” Wall St r eet is w at ching t he pr icing and t er m s of MI Ps licenses,
and capit alizing t he infor m at ion int o t heir st ock pr ice. As t he m ar ket s cont inue t heir
w or k t o pull t hese for ces t oget her , it is not unr easonable t o expect a publicly t r aded
com pany t o have cont ract s disciplined by ot her pricing of risk and ret urn in t he
m arket s and by t he alt ernat ives provided by it s ow n physical asset s.
10/ New Econom y or Dow : You’ve got t o ask t he r ight quest ions
New Econom y firm s w rest le w it h t he I nt ernet , t he e- com pany, digit al plum bing, and
int ellect ual pr oper t y. And t hese issues t hr eat en t he business m odels of m ost
sm okest ack indust ries as w ell. From Hallm ark t o Fed Ex t o General Mot ors,
t echnology is st ar t ing t o set off a t idal w ave of change. To m ake sense out of t his
enorm ous and broadbased phenom ena, w e need a new fram e of reference, a new
w ay of t hinking. And w e need t o collect new and differ ent kinds of infor m at ion.
We’ve got t o st art asking t he right quest ions: What are t he drivers of uncert aint y?
What ’s it s m agnit ude? Wher e ar e t he decision point s? What ar e oppor t unit ies t o
incr ease upside pot ent ial? What ar e t he oppor t unit ies t o lim it losses? At w hat cost ?
What w ill it t ake t o r em ain flexible? When is it w or t h it ? Can w e get our flexibilit y
and opt ions m ore cheaply t hrough cont ract s? And so on.
Wit h st andard approaches and t ools, it s going t o feel like you’re on a lifeboat
in a sea of chaos. Change your t hinking. See how t o cr eat e value out of
uncert aint y, and how t o rem ain a nim ble com pet it or – always afloat – as t he waves
of change r oll t hr ough.
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A Real Options Application:
The Strategy and Valuation of a New Venture
To make the real options approach concrete, let’s walk through an example.
We’ll lay out the flow of calculations here and present the results. If you would like to
see more detail, download the spreadsheet at
www.real-options.com/jbs.htmlPortlandia Ale is two guys and a dream. The company needs $4 million to begin
product development and manufacturing and another $12 million in two years for its
market launch. The entrepreneurs are very optimistic about their business opportunity,
despite considerable uncertainty about the value of the market opportunity they’re
chasing.
[Figure 1 about here]
Portlandia is showing potential investors a traditional business plan. $500,000
would be spent each quarter for the first two years. Then $12 million would be spent in
the first quarter of the third year to launch the product line. The business plan assumes
the launch would be successful, leading to a sustainable business with a market value of
$22 million. (The value of the sustainable business is calculated as: M/S x Portlandia’s
sales, where M/S is the average market value to sales ratio for mature microbrewery
companies.)
Even under two optimistic assumptions –business conditions will support the
sales forecast in the plan; and the launch will be made – the value of Portlandia under the
traditional business plan is
negative $230,000.
The business plan fails to include the valuable option held by the startup:
Portlandia need not undertake the market launch. The launch will only be made if
business conditions are strong enough to make the launch profitable. Portlandia’s
strategy is more complex and its valuation is higher than is recognized by a traditional
business plan.
The Black-Scholes equation is a well-known formula for pricing financial option
contracts and can also be used to value Portlandia’s launch option. The formula – for
which Myron Scholes and Robert Merton won the 1997 Nobel Economics Prize –
requires only five inputs to produce a single output, the current value of the option. (A
note of caution: not all real options can be valued so easily. Many corporate options are
more complex and require tailored mathematical formulae. (See the website for the
Black-Scholes calculations for this example and for more information on other methods.)
Now let’s more realistically characterize Portlandia’s strategy by adding a second
option: the option to abandon. Suppose that at any time during the first two years
Portlandia could cease operations if business conditions soured to such a level that
Portlandia could not see making the launch. The calculations are now a bit more
complex, and require specialized mathematical tools known as numerical methods
--tools widely used in engineering, science and on Wall Street.
The option to launch and the option to abandon are valued in an integrated
manner, resulting in a $1.74 million valuation for Portlandia. The traditional business
plan undervalues Portlandia because it fails to recognize that the company will be using a
