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Table of contents
- Finance and Risk Management
- Why risk management is important
- Applying the Discipline
- Day Trading Risk Management and the One Percent Rule
- Risk Management
As complexity and distance increase, customized valuation models become necessary. At some point—which we call the real-options frontier —decisions become so complex and so distant that valuation becomes impracticable with existing tools. In this exhibit, we plot the three cases examined in this article according to their complexity and distance. The decisions faced by Portlandia Ale and, in particular, Eastern States Mortgage are much further from the market; they require more highly customized models.
The frontier of the real-options approach continues to expand outward as new markets emerge. Many real options that would have been impossible to value objectively a few years ago can now be valued with a high degree of discipline. Chicago Soy Processing has long-term fixed-price contracts to buy crops from several farmers. Each year, it knows the price it will pay for beans but not the quantity it will have to buy. The company needs to decide whether to build a new plant to process the beans or to reserve capacity from another processor.
One of the most valuable would be the option to shut down the plant temporarily—and thus save considerable operating costs—during times of low supply. The shutdown, or mothballing, option has value because it mitigates risk, providing Chicago Soy with flexibility as it responds to the uncertainties of its business. To accurately gauge the overall value of the plant, the company needs to account for the value of the mothballing option as well as the value of the other options it will gain.
By looking to the financial markets, Chicago Soy can gather information it will need to think through the value of its options and arrive at the best decision. When the spread is large, less-efficient plants are drawn into the market, but when the spread narrows, the less-efficient plants become unprofitable and are shut down. The crush spread, in other words, reflects the efficiency of the least-efficient active processor. By looking at the prices of crush-spread futures, the company can see if it would be able to process the beans efficiently at the time of the harvest.
Even more important, it gains insight into the longer-term value of the new plant. Looking at a range of crush-spread futures for a succession of delivery dates can tell the company what levels of processing efficiency its plant will need in order to be profitable at various points in the future.
Finance and Risk Management
Chicago Soy can use this information to project when it would make economic and competitive sense to shut down its new plant and to determine the impact of those shutdowns on overall plant profitability. It thus gains an objective measure of the value of the mothballing option.
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Because it costs money to shut down and reopen a plant, mothballing decisions should not be made purely on the basis of the current or projected crush spread. By examining the volatility of the futures contracts for crush spreads, the company can glean information about the uncertainty of the price forecasts. If, for example, the spread is highly volatile, the company may want to hold off on shutting down its plant even when the spread narrows to the point where the plant is unprofitable. The possibility that the spread may soon widen—and the plant may again become profitable—argues for a delay in incurring the shutdown costs.
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By looking at the volatility of the crush spread, Chicago Soy thus gains an even more accurate sense of the value of its mothballing option and of the new plant in general. The information drawn from the financial markets is not just useful for evaluating investments and plotting strategy. It can also be applied to tactical operating decisions. In making such operating decisions, the company can now take into account not only the current and expected future prices of beans and oil but also the volatility of those prices.
If it turns out that an investment in a new plant is not economically justified, market information can help Chicago Soy think in a disciplined way about its options for reserving capacity at another processor. Looking at the crush-spread futures, it can infer a market price for the capacity at the time Chicago Soy will require it, thus giving the company an objective benchmark for evaluating the terms of any contract it may be offered.
Depending on what it learns from the markets, Chicago Soy might want to explore various contractual alternatives.
Why risk management is important
It may, for example, want to make a commitment to take the reserved capacity regardless of the size of the harvest. Or it may want to negotiate an option on the capacity, paying a small amount now for the opportunity to preserve flexibility at harvest time. It may also decide to shift some of its risk by selling futures contracts on the beans it will receive. Now think about how Chicago Soy would operate without a disciplined decision process.
First, it would develop private forecasts of prices, ignoring the information in the market securities. Second, it would overlook the value of the operating options the new plant would provide, leading it to underestimate the value of investing in additional capacity. Third, it would develop some scenarios about the harvest—big crop, medium crop, small crop—and then assign subjective probabilities to them.
Such scenarios would highlight the value of flexibility, but they could also lead to subjective trigger points. The company might keep a plant open too long, operating when the crush spread is too narrow to turn a profit. Or it might keep a plant closed too long, forgoing profits. Finally, traditional analyses tend to focus solely on physical capacity, overlooking the potential for acquiring options through contracts.
Portlandia Ale exists only as the dream of two young brew masters who yearn to go into business for themselves. The key question facing them, and their potential investors, is this: Is Portlandia Ale a viable business opportunity? A traditional valuation analysis would seek a single precise answer. One can easily imagine the spreadsheet that would be used. The first row would show steadily growing revenues; the second row would display gross profits.
Lower down would be a row with the planned investments—a few cells containing large negative cash flows. The net cash flow would be calculated along the bottom row. In the bottom right-hand corner, where the forecasts of net cash flows end, would appear the final entry: the net cash flow at the end of the forecast period multiplied by the average price-earnings ratio for microbrewers.
This figure, known as the terminal value, represents the value of the continuing business after the last year shown on the spreadsheet. The value of the proposed microbrewery would then be calculated as the present value of the forecasted stream of net cash flows. The traditional analysis would conclude that Portlandia is a viable opportunity if its present value is positive.
First, the real world is uncertain. Any forecast is but one of many possible outcomes. Second, traditional analyses tend to build a positive outcome into the calculations. That means a positive net present value is usually based on only a short period of profitable operations and a terminal value whose magnitude is suspect.
Because the terminal value is so easy to manipulate, traditional business valuations are fundamentally undisciplined and fundamentally unreliable. A better way to approach the valuation is to look at the opportunity as a succession of growth options. But it does not obligate them to make those investments.
In making a valuation, then, the right question to ask is not What return will we gain from our investment in this company? Answering that question leads naturally to the answer to the key strategic question: What growth strategy will create the greatest value? The growth options have value because the future is uncertain. By buying the initial option, the investors gain access to the potential upside while limiting the losses they would incur from unfavorable outcomes. In two years, when they arrive at the next decision point—the next option-buying opportunity—some of the uncertainty will have been resolved, and they will be in a better position to make a new investment choice.
Applying the Discipline
If Portlandia is struggling, they may want to hold off on further investment. The options-based approach to valuation mirrors the reality of management: every investment decision you make changes the set of investments you can make in the future.
The value of the growth options is calculated by first determining the value of the mature business once all options have been exercised and then measuring the uncertainty of actually realizing that value. Both can be derived from market information. The value of the mature business can be based on stock-market ratios—such as price-to-sales and price-to-cash-flow figures—for existing mature microbreweries.
Day Trading Risk Management and the One Percent Rule
And the measure of uncertainty can be based on the historical volatility of microbrewery stocks. Once you know the volatility, standard option-pricing formulas can be adapted to determine the option values. As the Portlandia example demonstrates, the growth-option framework works well for valuing new companies in established markets where the stock prices of existing companies provide benchmarks. But is the approach applicable in new markets? The answer is usually yes, although the approach will vary slightly depending on whether the new market operates according to established business models or according to new, evolving models.
Kendall Square Research in Waltham, Massachusetts, is an example of the first situation. The company was the first maker of massively-parallel-processing computers to go public.
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But while its product was entirely new, its business model closely followed that of other big-computer makers. Netscape is an example of the other situation. There were no similar companies. But even though the links to market discipline were weaker, they were not nonexistent. The CIO argued that an enhanced system, with state-of-the-art image-processing capabilities, would enable Eastern States to significantly improve its customer service, leading to stronger growth.
At first glance, a decision about an IT upgrade would seem to have little to do with the financial markets. The big risks all appear to be unique to the company. Will the company be able to bring in the system on budget and on time? Will its people be able to change the way they do business?
Will the new image-processing capabilities really make a difference in how customers perceive their service? With better information-processing capabilities, Eastern States would gain new growth options and new operating options. It could, for instance, begin to customize its mortgage packages to the needs of individual customers, providing opportunities to further increase demand.
And it would be in a position to reduce its costs by more efficiently delivering mortgage pools to the financial markets. When the managers began to think in terms of options, they saw that the investment in an upgraded system should be considered not as a single up-front cost but rather as a series of investments made in stages. The conclusion of each stage would provide a new set of options for continuing, revising, or abandoning the initiative.
To be able to explicitly evaluate all the options, the managers structured the proposed upgrade into three stages. The initial stage consisted of a pilot project conducted in one region. The pilot project would show management whether or not the new technology could be implemented and used successfully by the company.