What is a Real Option in an investment? This is a very hard question to answer because it involves an understanding of investment options and what they mean. Like with most things I think the best place to start the conversation is with the basics.
An option in investments is a security which gives you the right but not the obligation to buy or sell something (like a stock). Whether or not you will want to exercise your right is dependent on the price of the underlying security which your option is based on. Investment options always set a price at which you can exercise your option. This price is called the “strike” price. The strike price is always going to be the price you buy or sell at when exercising your option. The “option” part of the option is that you are not required to exercise your right. You have the option to walk away if you want to. If you own an option to buy a stock, you will want to exercise the option if the price of the stock is higher than the strike price. If you own an option to sell a stock, you will want to exercise the option if the price of the stock is lower than the strike price.
A simple example helps illustrate this. I buy a call option on Alibaba stock. My option gives me the right, but not the obligation to buy 1 share of Alibaba at a strike price of $170. The current price of the stock is trading at $260. I will clearly want to exercise my right because I can buy the stock at $170 by exercising my call option, and then I can turn around and sell it in the market for $260 for a quick profit of $90.
Why wouldn’t I just buy the stock directly? The option allows us to achieve leverage by achieving high gains without putting as much money at risk. If I paid $30 for my Alibaba option above, my profit is $60 ($90 difference between the strike price and the market price - $30 cost of purchasing the call option). The $60 profit represents a 200% return on my $30 investment. If I had simply bought the stock at $170 and sold it at $260, my profit would be $90 but my percentage return would only be 53% because I had to put much more capital at risk to achieve that return. If we wanted to compare apples to apples, we could have bought $170 worth of call options as opposed to only $30 worth. In that case my return on my options would still have been 200% but the dollar return rises to $340 profit. That’s the power of leverage.
So now that we hopefully understand a little bit about how options work, we can start to talk about real options and how great they can be for an investor.
One of the things that has been most surprising about modern day technology companies is their ability to transition to wholly new areas of business and to quickly dominate and disrupt the incumbents very quickly. One of the best examples of this was Amazon with its cloud business.
Amazon needs vast amounts of computer servers to run its e-commerce business and one day they decided that they would offer their excess server capacity up to customers as a rentable cloud service. This business model took off and is now arguably more valuable to Amazon then the original e-commerce business is. But before Amazon had signed up any customers for its cloud, all they had was essentially an option to pursue cloud as a new business. They had the option to pursue the cloud business to see if it worked, and if it didn’t they could simply stop doing it and go back to working on their e-commerce business, or perhaps a new idea. This was a real option that Amazon had.
How do we value this Real Option when we see them? With great difficulty.
Real Options are based on very uncertain outcomes. Sure Amazon’s cloud business took off and is extremely valuable now. But no one could have predicted with certainty that would be the case when they launched it. The outcome was very uncertain which reduces the value of the Real Option.
On the other hand, the cost of implementing the option was very low. Amazon already had all of the server capacity to start the cloud business. So just like my call options above, the potential payoff was high, the outcome was very uncertain, but the amount of money that would be put at risk was also minimal. This is not a bad deal at all! One thing is certain, if you were valuing the Amazon business pre-cloud and you failed to account for the value of this Real Option to move into the cloud business, you totally missed the boat.
Most if not all businesses have some Real Options in there business. Some are more entrenched than others, but management in even the most entrenched businesses do have options in their business which could dramatically change the value of the business. There’s no better example then Berkshire Hathaway. Berkshire was originally a textile company that by the 1960s was a chronic money loser due to cheap foreign competition. However the business did have cash on the balance sheet. Warren Buffett used that cash to buy an insurance company (National Indemnity) and quite rapidly the business transformed from a textile manufacturer to one of the broadest and largest conglomerates in the world. The potential to invest Berkshire’s cash was a Real Option, with a very uncertain outcome, and a potential big payoff. If you valued Berkshire based on just the value of the textile business, you totally missed the boat.
With modern day tech companies, we see that they have a lot of Real Options in their business. They have a lot of cash at their disposal as well as a lot of employee talent. But more importantly then this, many of these businesses have a platform with which they can easily launch offshoot businesses that capitalize on their existing customers or their existing users. Apple has over a billion customers who buy their products. So when Apple decides to launch a video streaming service, or a car company, or even a bank, they have a billion captive customers who are plugged into the Apple ecosystem which they can sell to. This means that Apple has so many ways that they can monetize the loyalty that their customers have. Maybe all of these new Apple businesses will be failures, but one thing we can say for sure is that they are not guaranteed to be failures, and the potential payoff for any one of these Real Options could be huge!
The same can be said, for Alphabet, Facebook, Microsoft, and the aforementioned Amazon, all of whom have a lot of Real Options in their business which are hard to quantify at this point.
So how do we account for the value of these Real Options when we invest in a company? Well, we could use models used to value investment options as a guide. This follows the Black-Scholes model of option pricing which is complicated and not very useful for your average retail investor. We could value the options that way, but I think there is a better way to account for them.
In my world the best real options are the ones we don’t have to pay for. There are companies which have these Real Options, but the current market price doesn’t seem to be assigning any value to these options. Essentially by buying the stock you get the Real Options for free. This is like getting a free lottery ticket. Even if the chances of winning are very low, it’s still a great deal because you didn’t have to pay anything for it.
It’s also important to note that just because a company has these Real Options, does not mean that you should be willing to pay any price for that company. You can still overpay for a Real Option even if the potential payoff is huge. For every Amazon Web Service there is a Blockbuster Video who failed to execute on the Real Options present in their business.
These kinds of Real Options can be tough to identify, and can be really tough to value. But they are nevertheless a key tool in our toolbox for investing today. If you’re not identifying them, you might be missing the boat.
- Craig White, BA, LL.B., CIM®
Craig White is an Investment Advisor at Endeavour Wealth Management with iA Private Wealth, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for iA Private Wealth and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.