1. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 1 of 29 Choice of Valuation Methods Richard de Neufville Professor of Systems Engineering and of Civil and Environmental Engineering MIT

2. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 2 of 29 Outline for Real Options l The Issue l Criteria of Choice –Analysis Objective – choice or price? –Organizational Decision-Making practices –Analytic Capabilities of Group –Information available l Two Classic Cases – Real Options at: –Merck – Producer of Ethical Drugs –Kodak – Cameras, Copiers l Summary

3. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 3 of 29 The Issue: Choice of Method l Why is this a Question? l Why not most theoretically correct method? l Not obvious which method is correct –Elegant theory based on assumptions –If these are not credible, theory may not apply Simple Idea – almost theological issue for some l If objective is to influence design … …Then what works is what counts! –Need to appreciate resources and constraints that apply to process of valuation

4. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 4 of 29 Possible Goals of Valuation l Psychology Offers 2 General Possibilities –Choice: specifies ORDER of preference –Judgment: measures INTENSITY of preference l Choice is easier task –Requires less cognitive effort l Judgment more difficult = ‘choice’ + measure –Requires more conditions if you want to get a consistent measure (see “primitive models” presentation, also ASA Chapters 18-20) l Which applies to current situation?

5. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 5 of 29 What is Goal in Current Situation? l Definition of a Strategy? –Ex 1: Communications Satellites – should system be built all at once to a specified capacity? start small with capability to expand? –Ex 2: Logistics – should configuration of system be Centralized -- or distributed? l Finding best Option among many? –Ex: Having chosen strategy to build factory extra large to permit expansion, what is best size? l Any Organization or design team can face either issue at different times…

6. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 6 of 29 Which method for goal? l Two major alternative methods: –Decision Analysis (Tree or Lattice) –“Options Analysis” (Risk-neutral analysis, etc) l Decision analysis focuses on –choice, on developing strategy l “Options analysis” focuses on –Judgment, the pricing of any option l Therefore: Analysis Objective of Valuation exercise should influence the selection of method

7. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 7 of 29 Organizational Practices l Groups differ in project evaluation practices l This matters! –easier to make incremental improvements –hard to make deep changes l To influence the actions of groups now… may be best to aim for smaller changes l Major differences in evaluation practice from our perspective are in how groups –Model uncertainty –Value uncertainty

8. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 8 of 29 2-D View of Evaluation Practices l Groups differ in project evaluation practices l Where do we place group we are working with? Valuation of Uncertainty DCF Modeling of Uncertainty “Options Analysis” None Lattice etc

9. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 9 of 29 Example: BP Projects l Central Management defines –Discount rate –Price of Oil to be used in Evaluation –Evaluation Method -- DCF l Project Chiefs may not alter –Central Management does not want to be gamed l Result: –Technical Uncertainty Considered –Market Uncertainty in Price is Ignored –No Risk-Adjusted Discount Rate –No options analysis of projects

10. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 10 of 29 What Method for BP? l Likelihood of getting Central Management to let project managers use “options analysis” is very remote – DCF is standard l If object is to add value to projects using options, seems best to evaluate them in a way compatible with DCF (cf: Woolley, 2005, “Thinking out of the box”) l In short, Organizational Evaluation Practices should influence the selection of method

11. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 11 of 29 Analytic Capabilities of Group l To implement evaluation of options for a project, it is necessary to work with project proponents – they control process and data l Are they –Engineers? – oriented toward decision analysis –Financial Managers? – trained in options analysis l As a practical matter, Analytic Capabilities of Group will influence the selection of method

12. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 12 of 29 Information Available l “Options Analysis” requires extensive data: –Price of Asset –Standard deviation of asset value These may not be available l “Options Analysis” also assumes: –Existence of Efficient Market for Asset This may not exist Thus, Availability of Information will constrain the selection of method

13. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 13 of 29 Also Keep in Mind... l Level of required effort, ease of use – for both –developers of analysis – who have to do work –Clients – who have to understand, if they are to act l Financial models work well with –1 or 2 variables with market price history l Decision analysis works well when –Likelihood, timing of uncertainties understood –Information sources focused on individual project –Important Variables do not have price history

14. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 14 of 29 Choosing Valuation Method in Practice l Compare efforts at two companies – Good Examples of Factors defining Choices l Merck: used financial approach to options l See: Nichols, N.A. (1994) “Scientific Management at Merck: an interview with Judy Lewent,” Harvard Business Review, Jan-Feb, 89-99 l Kodak: used decision analysis l See: Faulkner, T.W. (1996) “Applying Options Thinking to R&D Valuation,” Research Technology Management, May-June, 50-56

15. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 15 of 29 Merck – the company l Developer, producer of ethical drugs l Spends billions on Research and Development –Thousands of candidate compounds –Hundreds of possible drugs –Tested in a controlled sequence of trials l Understands that R&D creates options – Successful Research gives “right, but not obligation” to proceed to next phase of development l Has extensive group for “options analysis”

16. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 16 of 29 Merck -- Business Details ● Development process highly regulated by FDA ● 1000’s of candidate drugs go through 10 year path to market provide statistical database ● Reasonable to speak in terms of an average project and estimate volatility Pre- Clinical Tests Phase- One Clinical Phase- Two Clinical Phase- Three Clinical FDA Filing On-going Basic Research Compound Discovery

17. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 17 of 29 Merck – the Real Options Case l Project Gamma –Opportunity to work with Start-up Biotech Company –Merck would fund continuation of R&D –Merck would get right to buy Start-up in 2 years –Start-up gets opportunity to continue, and cash out l Investment in R&D buys option for production in 2 years -- a “European” call l “Options analysis” used to value development contract with biotech company l Let’s see how and why…

18. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 18 of 29 Merck – Analytic Context l Goal of Analysis: To determine Price of Option l Location of Analysis: Finance Department –Acquisitions one of their responsibilities –Had extensive experience with financial options l Information plentiful –Deep statistics on success rates for new drugs –Much data on performance biotech start-ups l Choice of Method: Financial “options analysis”

19. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 19 of 29 Merck -- Information Details l Average drug takes $359 million and 10 years to market ● 1/10,000 compounds tested becomes a drug ● Fraction of population with disease X known ● Successes and failures at each testing step documented and averaged ● Database of pharmaceutical and biotech stock performance created

20. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 20 of 29 Analysis for Merck Case l Project Gamma as a European call option l Valuation procedure ─ Asset = Stock in Start-up Company ─ Value of Asset = value of projected cash flows ─ Strike Price = Cost of manufacturing scale-up ─ Risk-free rate = rate on U.S. Treasuries ─ Volatility based on stock market performance of comparable biotech companies in database ● Sensitivity Analysis ─ Volatility: varied between 40 to 60 percent ─ Time to Expiration: varied between 2 to 4 years

21. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 21 of 29 Merck -- Real Options Summary l Merck needed to determine price l Valued real options using financial “options analysis” – Black-Scholes formula – Other models for support (Monte-Carlo simulation) – Applied to variety of areas: R&D, acquisitions, etc... l Recognized imprecision due to assumptions –Sensitivity analysis on volatility, time to exercise –This helps to address remaining uncertainties

22. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 22 of 29 Kodak – the Company l Involved in multiple businesses: film, printing, etc., besides production of copiers l “average project” hard to define ─ Product development processes might be similar, but do vary ─ No comparable data available publicly, from either FDA or start-ups in copier industry (none exist) l Data needed for a financial analysis not available

23. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 23 of 29 Kodak – the Real Options Case l Color Printer Project –R&D project run by engineers –Faces technical and market uncertainties –Decisions on R&D and production are separate –Production can be started ‘any time’ after R&D l Investment in R&D creates “right, but not obligation” to move into production – An “American” call l Decision analysis used to “green light” R&D l Let’s see how and why…

24. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 24 of 29 Kodak – Analytic Context l Goal of Analysis: to choose R&D strategy l Location of Analysis: Systems Engineering group –Not up on financial “options analysis” –R&D department used to decision analysis l Information available: –Estimates of Probability of Technical Success, Market Size for Project –No comparable statistical data on volatility, etc. – Projects vary widely between and within business units – Difficult to assemble relevant databases l Choice of Method: Decision Analysis

25. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 25 of 29 Analysis for Kodak Case l Color printer project as American option l Valuation Procedure – Asset value = based on Project cash-flows – Strike price = Production scale-up costs – Discount rate = 12% – Timeframe was two years (1993 – 1995) – Volatility of payoffs implied by range of outcomes ● Sensitivity Analysis ─ To check robustness of decision to do project

26. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 26 of 29 Kodak – Real Options Summary l Kodak needed to choose a strategy –Proceed with R&D or not l Valued Real Options using Decision Analysis l Emphasis on value of “options thinking” –Recognition of flexibility (Kodak can decide not to produce copier, even if R&D is successful) –Exact value of option not important so long as it is greater than cost of R&D –Big advance over DCF with no flexibility

27. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 27 of 29 Lessons from Cases l Both financial “options analysis” and decision analysis can be used to value real options l Which can be used depends on context l Which should be used depends on goals, etc l Beware of false sense of precision – any method uses assumptions – Sensitivity Analysis always needed l Significant value in the mind-set -- Approximations can enable vast improvement

28. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 28 of 29 Summary l Choice of Valuation Method depends on –Analysis Objective – choice or price? –Organizational Decision-Making practices –Analytic Capabilities of Group –Information available l Most useful, productive method represents a balance between “theory” and “practicality” l Great accuracy generally illusory, due to many assumptions that must be made l Much Value in “Options Thinking”

29. Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Choice of Valuation Method Slide 29 of 29 Some References –Investment Science, Luenberger, 1998, Oxford U. Press. –Real Options, Lenos Trigeorgis, MIT Press 1996 –Investment Under Uncertainty, Dixit and Pindyck, Princeton U. Press, 1994 –Real Options in Capital Investment, Trigeorgis, ed. Praeger, 1995 –Project Flexibility, Agency and Competition, Brennan and Trigeorgis, eds, Oxford U. Press, 2000 –Real Options and Investment under Uncertainty, Schwartz and Trigeorgis, eds, MIT Press, 2001 – J. of the Financial Management Association, 22(3), Autumn 1993 (Special Section on in Real Options …)