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| Wood turners and potters understand two things that a lot of chief executives don’t: The future is shaped on the fly, and a predictable number of creative experiments shatter on the lathe or in the kiln. In their book Real Options: Managing Strategic Investments in an Uncertain World, authors Martha Amram and Nalin Kulatilaka lay out analogous insights in a way that may help executives make hard choices about strategy. Amram and Kulatilaka stand on the shoulders of giants: the Nobel Prize-winning work of Fisher Black, Robert Merton, and Myran Scholes on the pricing of options in financial markets. Amram and Kulatilaka explain how corporations can use classic options-theory to quantify the value of "real options"—whether to build a manufacturing facility, create a product, or launch an Internet venture. The authors also explain how to use options theory to manage such real-world projects as they mature—in other words, as their option value changes. Of course, many executives intuitively understand the option value of projects. If you listen to boardroom discussions, you’ll hear statements like, "At least we’ll learn something from this." Or, "This project will position us for the future." What Real Options adds is a framework for evaluating business-investment choices in a quantifiable way. While the framework is no theoretical breakthrough, it does a good job of helping executives take into account both volatility and the learning that may come even from a project that doesn’t provide much of a return on the investment. The book is best read as a collection of techniques and cases that can let executives look at business decisions in new ways. For one, the authors use the pharmaceutical industry to show the value of building a large portfolio of options. Drug makers can’t make just a few big bets on new drugs, because the odds are so high that any given project will fail. So, the companies invest small bits of money in tens of thousands of ideas, each of which has an option value. The companies aggressively kill off failures, while investing more heavily in options whose values are increasing. Eventually, the companies roll out a few huge winners. The authors also describe how to calculate the value of "increasing-returns" businesses—companies that have high start-up costs and low marginal costs and that build unbelievable momentum if they can establish themselves as a standard among consumers. Microsoft’s operating-system business is the best-known and most profitable increasing-returns business, but lots of software, hardware, and Internet businesses can become licenses to print money. Amram and Kulatilaka argue that winning is all that matters in increasing-returns businesses, and that corporations are often justified in investing incredible amounts in the attempt—as long as they make intelligent decisions about the expenditures at each step along the way. The authors also show that it often makes sense to share the wealth with partners. The authors cite Palm Computing’s efforts on personal digital assistants. Palm’s first effort failed, partly because it tried to do everything itself. The second time, it did a better job of lining up software companies to develop applications for the Palm Pilot. Palm was conceding revenue that it might have captured for itself, but the partners helped the Palm succeed, and that was far more important. Unfortunately, Amram and Kulatilaka kiss off the evaluation of e-commerce projects in a couple of pages. The authors’ main point is that big corporations’ "dot-com" ventures are "options on options on options on options to generate cash flow." Their advice: "If you don’t start the sequence, you won’t resolve the uncertainty about your business model, and you won’t have the market intelligence to migrate with the shifts in business models." Although this reasoning is unassailable, it leaves the reader yearning for a really good case study to explore these issues in more detail. Logically, the sequel to Real Options ought to roll off the presses just as soon as the authors learn how to apply their framework to launching an Internet venture. In the meantime, though, the book’s Web site (www.real-options.com) has validated the authors’ observations about the Internet. It has shifted from its original design and become a community of "real options" practitioners who share ideas and war stories about using the approach in the field.
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