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Reading notes: Strategy as a portfolio of real options

A valuation approach that appreciates learning and adapting to market changes.

Bruno Pešec
Bruno Pešec
3 min read
Strategy as a portfolio of real options

Table of Contents

These are my reading notes for Strategy as a portfolio of real options 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 options), 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
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
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
Weatherize’s Strategy as Nested Call Options (Luehrman, 1998, p. 96)


Luehrman, T. A. (1998). Strategy as a portfolio of real options. Harvard Business Review, 76, 89–101.


Bruno Pešec

I help business leaders innovate profitably at scale.


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