Demystifying real options
Do your agribusiness investment decisions involve large amounts of capital, long investment horizons and uncertainty?
If so, real options analysis could help you to better value, plan and manage your investment as events unfold.
What is real options analysis?
Real options analysis (ROA) is a valuation tool for planning high risk investments. Using ROA, decision makers can more effectively target crucial opportunities to accelerate, redeploy, delay, modify or even abandon capital-intensive investments as events unfold and new information comes to light.
ROA is particularly useful for investments in agriculture that involve large sums of money, long investment lives and that are not easily valued using a market-based approach.
While it hasn’t seen widespread adoption because of its complexity, ROA is increasingly being considered the most accurate for high risk investment planning than the more commonly used tools (such as discounted cash flow and net present value). For example, investments can be undervalued and rejected using the more commonly used tools but accurately valued and accepted using ROA.
Why is real options analysis powerful?
Investments in agriculture can be risky, with uncertainties such as weather and the incidence of pests and disease. This is on top of the more common investment uncertainties, such as demand, regulatory and commercial uncertainties, that apply to most industries and investment situations. Many investments facing uncertainty – new technology, research and development, product and geographical expansion – often involve multi-phased decisions where management bases its decision to continue to the next phase on new information.
ROA is able to alter strategy as new information is received. This is because ROA assumes management is able to proactively adapt to positive outcomes by scaling up or react to negative influences by decreasing its exposure. ROA is also able to account for changes in risk over an investment’s lifecycle.
Using real options analysis in agriculture
ROA has been long used for strategic investment planning by several industries including pharmaceutical and biotech, energy and mining. More recently, ROA has been used in agriculture to value high risk investments as well as investment-related government policies. For example, ROA has been used to:
- Evaluate the potential returns from investment in either precision agriculture technology or conventional sowing and harvesting technology1
- Assess the impact of different agricultural policies (such as price floors, investment subsidies and production ceilings)2
- Evaluate the potential returns from investment in either new perennial pastures for beef-trading or volunteer annual pasture for Merino ewes after extreme drought conditions in Western Australia reduced pasture availability and herd numbers3
- Assess the potential value of increased drought tolerance in genetically modified (GM) canola4
- Assess whether farmers in wheat dominant agriculture will adjust their practices and technologies as a result of climate change5
- Evaluate profitability and market success of GM crops in volatile market and regulatory environments, comparing developing countries with industrialised GM-adopting countries6.
When should you use real options analysis?
So how do you know if you should use ROA when you plan your next investment? There are a few key things to look out for:
1. Does your investment involve large upfront costs and long timeframes?
2. Does your investment involve uncertainty about the future? In agriculture, there are many uncertainties, including:
- Environmental factors such as changing climate, drought, floods, agronomic performance of crops, and the incidence of pests and diseases
- Commercial factors including consumer demand growth and changing consumer tastes, and operating environment factors such price signals, licensing approvals, regulations, intellectual property protection, market entrances and competition
- Technological factors, for example the technical success of new technologies and government policy in support of new agricultural technologies
- Financial factors which can be a function of investment duration, investment cost, expected revenue, financial viability, interest payments, multi-party collaboration and cooperation, and realisation of economies of scale and scope.
3. Are there options to change your investment strategy? The flexibility available to management (i.e. the 'real options'), generally relate to:
- Investment size decisions (to expand, contract or maintain)
- Timing decisions (to start, abandon, phase/stage, delay/wait for new information to resolve uncertainty)
- Optimising the operation of the investment once it has started (to mix outputs/products, inputs/processes or change operating scale).
So real options analysis could help you proactively manage or get more out of your existing investments, or help you identify investment opportunities that others have passed over.
Director, Deloitte Access Economics
1. Tozer, P. (2009). Uncertainty and investment in precision agriculture - Is it worth the money? Agricultural Systems, 100, 80-87.
2. Feil, J.,Musshoff, O. & Balmann, A. (2013). Policy impact analysis in competitive agricultural markets: a real options approach. European Review of Agricultural Economics, 40(4), 633-658.
3. Tozer, P. & Stokes, J. (2009). Investing in Perennial Pasture Improvement: A Real Options Analysis. Review of Agricultural Economics, 31(1), 88-102.
4. Wynn, K., Spangenberg, G., Smith, K. & Wilson, W. (2017). Valuing Genetically Modified Traits in Canola Using Real Options. Journal of Agricultural and Resource Economics, 42(2), 195-214.
5. Hertzler, G., Sanderson, T., Capon, T., Hayman, P., Kingwell, R., McClintock, A., Crean, J. & Randall, A. (2013). Will primary producers continue to adjust practices and technologies, change production systems or transform their industry – an application of real options. National Climate Change Adaptation Research Facility, Gold Coast.
6. Nadolnyak, D., Miranda, M.J. & Sheldon, I. (2011). Genetically modified crops as real options: Identifying regional and country-specific differences. International Journal of Industrial Organization, 29(455-463).