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# Reading notes: Strategy as a portfolio of real options
- URL: https://www.pesec.no/reading-notes-strategy-as-a-portfolio-of-real-options/
- Published: 2022-07-18T07:00:32.000Z
- Updated: 2022-07-18T07:20:53.000Z
- Description: A valuation approach that appreciates learning and adapting to market changes.
- Author: Bruno Pešec
- Tags: Notes, #RealOptions, #Innovation Accounting, #table-of-content

*These are my reading notes for [Strategy as a portfolio of real options](https://hbr.org/1998/09/strategy-as-a-portfolio-of-real-options?ref=pesec.no) by Timothy A. Luehrman. I hope you find them useful.*

Discounted-cash-flow valuation doesn't value learning and adapting to market changes, as it assumes following a fixed predefined plan.

Luehrman extends his previous framework in which he introduced valuing the projects as real options (see *[Investment opportunities as real option](https://www.pesec.no/reading-notes-investment-opportunities-as-real-options/)s*), arguing that strategy consists of a series of options.

## A gardening metaphor: Options as tomatoes

Luehrman introduces tomato garden as his overarching metaphor, where tomatoes represent options, and garden being the portfolio. A good gardener knows when to pick up tomatoes, and how to tend after them in order to maximise garden's yield.

### A tour of option space

Luehrman defines the option space with value-to-cost quotient, $NPVq$, and cumulative volatility, $\\sigma \\sqrt{t}$.\* From there, he divides it into six regions, sticking with his tomato metaphor:

| Region | Metaphor                               | Invest?        |
| ------ | -------------------------------------- | -------------- |
| 1      | Ripe tomatoes                          | Now            |
| 2      | Imperfect, but edible tomatoes         | Maybe now      |
| 3      | Inedible, but very promising tomatoes  | Probably later |
| 4      | Less promising green tomatoes          | Maybe later    |
| 5      | Late blossoms and small green tomatoes | Probably never |
| 6      | Rotten tomatoes                        | Never          |

![The Tomato Garden](https://storage.ghost.io/c/72/d5/72d522ba-f2e5-4415-a19c-d8f567c36347/content/images/2020/07/The-Tomato-Garden.png)

The Tomato Garden (Luehrman, 1998, p. 93)

*\*For more details on $NPVq$ and $\\sigma \\sqrt{t}$ read Investment opportunities as real options: Getting started on the numbers.*

### Top of the space: Now and never

Regions 1 and 6 are straightforward. Cumulative volatility is zero, most likely due to time to make a decision running out. That means that we are basing the investment decision solely on value-to-cost quotient. If it is above 1 then we should invest, otherwise we shouldn't.

### Right side of the space: Maybe now and Probably later

Regions 2 and 3 are separated by conventional NPV, where NPV > 0 for former, and NPV < 0 for latter:

- Options in region 2 might be considered for early investment.
- Options in region 3 are promising, and need to be developed further. They shouldn't be invested in early.

Strong reason for early investment is if there is a high likelihood of predictable loss in case of a deferred investment. Unpredictable gains and losses are not a good reason for investing early.

Luehrman lists pending changes in regulations, a predictable loss of market share, or preemption by a competitor as valid examples for early investing.

### Left side of the space: Maybe later and Probably never

Regions 4 and 5 have conventional NPV < 0:

- Options in region 4 are more promising because they have higher cumulative volatility, meaning their value-to-cost ratio still has a chance to improve if they are given sufficient time.
- Options in region 5 don't seem very hopeful, but can be kept open until time runs out.

## When to harvest

In his example Luehrman analyses a portfolio that consists of six projects: 

![Vital Statistics for Six Independent Projects](https://storage.ghost.io/c/72/d5/72d522ba-f2e5-4415-a19c-d8f567c36347/content/images/2020/07/Vital-Statistics-for-Six-Independent-Projects.png)

Vital Statistics for Six Independent Projects (Luehrman, 1998, p. 94)

Traditional DCF analysis suggests that we accept two, and reject four projects, valuing the whole portfolio at \\$20 million. Options-based approach suggests we accept one and reject one project, while keep four projects open. It values the portfolio at \\$74 million.

## A dynamic approach

Left untouched, options tend to lose value because both value-to-cost and volatility metric decrease with passage of time.

Options can be improved by active management. Luehrman argues that managers find it easier to improve value-to-cost metric because it deals with common issues like managing revenues, costs, and capital expenditures

## Nested options in a business strategy

Luehrman introduces the concept of nested options, where options are connected. In other words, exercising one option has direct influence on all linked options. Real-options framework allows us to capture the value quantitatively, and the tomato garden allows us to visualise it:

![Weatherize’s Strategy as Nested Call Options](https://storage.ghost.io/c/72/d5/72d522ba-f2e5-4415-a19c-d8f567c36347/content/images/2020/07/Weatherize-s-Strategy-as-Nested-Call-Options.png)

Weatherize’s Strategy as Nested Call Options (Luehrman, 1998, p. 96)

## References

Luehrman, T. A. (1998). [Strategy as a portfolio of real options](https://hbr.org/1998/09/strategy-as-a-portfolio-of-real-options?ref=pesec.no). *Harvard Business Review*, *76*, 89–101.