Financial Strategy, Second Edition

CASE STUDY 3

Real Options

K. Leslie and M. Michaels

BEST PRACTICE IN MANAGING REAL OPTIONS

Two UK companies, BP and PowerGen, exemplify the benefits of real-options thinking. Between 1990 and 1996, BP increased its market value from $18 billion to $30 billion, representing a total return to shareholders of 167%. Over the same period, PowerGen raised its market value from $1.4 billion to $3.8 billion, a return of almost 300%.

In both cases, most assets and earnings were in mature industries. BP's exploitation of North Sea oil and gas field development options took place against a background of falling reservoir sizes and volatile oil and gas prices – quite unlike the boom days of the 1970s and early 1980s. PowerGen, for its part, has had to deal with barely rising demand, a saturated market and increasing competition to build new capacity.

Both companies managed to earn extraordinary returns in unfavourable environments because they followed a strategy of making incremental investments to secure the upside while insuring against the downside. They also delayed committing to investment until they had confirmed that it would be worth while, usually by acting on the six levers of option value.

Extending the Field of Vision

The application of real options steers management towards maximizing opportunity while minimizing obligation, encouraging it to think of every situation as an initial investment against future possibility. As a result, management's field of vision is extended beyond ...