Using Real Option Valuation Theory to Hedge Against Marketing Innovation Risk

The reality is no matter how committed your company is to innovating your marketing, another firm somewhere will think of something that could put your company at a  competitive disadvantage or be a real threat to your business. Its unlikely your firm has cornered the market on good innovative ideas that have the power to disrupt the industry.  Here we will briefly explain how to use real option valuation as a way to hedge that risk and possibly turn it into a competitive advantage.

Let’s start by defining real options valuation using Wikepedia -  Real options valuation, or real options analysis is the right — but not the obligation — to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. For example, the opportunity to invest in the expansion of a firm’s factory, or alternatively to sell the factory, is a real call or put option, respectively. Real options are generally distinguished from conventional financial options in that they are not typically traded as securities, and do not usually involve decisions on an underlying asset that is traded as a financial security.^[3]

An example might be when Barnes & Nobel was offered an opportunity to build an online store on AOL’s online store platform.  At the time, the AOL store looked promising for e-commerce because of the potential eyeballs AOL had, but e-commerce was still quite early. Barnes & Nobel did the calculation and didn’t see the ROI on this venture and passed.

Barnes & Nobel could have looked at this investment using real options analysis and came to a different conclusion, but we will never know. If Barnes & Nobel had built a store on the AOL site, they might have prevented Amazon.com from emerging. Potential investors in Amazon would ask, why do you think you can beat Barnes & Nobel in the online retailing of books given their existing brand and customer base, scale, etc? As such, it may have prevented new entrants.  New entrants are attracted in part because they see a “White Space” opportunity.

In a previous post we discussed the importance of having a, “test and learn” mentality. Being one of the first companies to be testing the concept of online book sales would have provided a great “test and learn” opportunity for Barnes & Nobel or Borders among others.

Using Barnes & Nobel as an example, here is how this would have worked. Barnes &  Nobel would have had to make an investment to get an online store up and running, trying to leverage the AOL traffic.  If the online store got traction, then the option of further investment had real value. If not, Barnes & Noble could have abandoned the project and let the option to maintain or expand expire worthless.

Let’s use another scenario. Say Barnes & Noble passes on AOL, but decides to invest in Amazon.com. The idea of selling online is intriguing, but they have done the math and don’t see the ROI. But they hedge their bets by making an investment in Amazon.com, even though that investment may turn out to be worthless as well. Remember, in the early days, Amazon.com was operating at a loss for years and some questioned if it would ever turn a profit.  These types of investments often come with the “option” to make further investments if there is a need for capital. If Amazon.com gained traction, Barnes & Nobel could have increased their investment in further rounds as most likely that option would have been part of their investment agreement. If Amazon.com went bankrupt, then the option for further investment would have expired worthless.

In terms of a hedge, think of it this way. Say Borders made the investment in Amazon.com and as Borders stock was declining in value, the investment in Amazon.com would have been appreciating. The investment in Amazon.com would have served as a hedge, or insurance. And just as you buy house insurance with the hopes you will never have to use it, not using it is not considered a negative ROI investment. The point is you are making investments in companies that have an alternative business model or way to do marketing, in this case a new channel, just in case this new way of marketing works and turns out to be disruptive to the industry.

One could have imagined Merrill Lynch taking this approach by making an investment in E-trade, Ameritrade or a number of other online traders or all of them as a “basket” as a way to hedge against this new way to selling securities, just in case it took off.  The idea is, knowing we won’t come up with all of the great marketing innovation ideas, how do we hedge or insure ourselves that one that looks silly today does not put us out of business tomorrow? Using real options theory is one such way. Understanding how to use real options valuation is just another tool a CMO should have in his or her tool kit when it come to managing marketing innovation risk.