ROI is Dead, Long Live ROI

Here's my second video blog. Click here to watch it.

frank

Comments:

Frank, you have performed a service by pointing out the flaws in traditional strategy and valuation methods. Ignoring relevant information, especially option value, causes large losses in corporate value every day. I’d like to propose a few more ideas for you to consider along the lines of including all relevant information and accurate valuation. In the late 1990s, according to CTO Magazine, around 80% of Fortune500 CTOs had at least experimented with Real Options. However, classical Real Options was a failure at that time and has been largely forgotten. The two main drawbacks were that the underlying variables must be assets (i.e., items that can be assigned a financial worth like the price of gold, oil, or a stock) and that only one or two variables can be included in a model. In general, Monte Carlo cannot be used to solve Real Options problems because the optimal strategy cannot be calculated in hindsight (nor can the proper discount rates be calculated). Solving Real Options problems without the aid of a financial theorist’s ‘risk-neutral world’ requires discount rates that vary both over time and scenario and require a software tool more sophisticated than Excel. Unfortunately, real business problems almost always contain many future decisions and multiple “non-asset” uncertainties (e.g., future quarterly sales or the possible passing of a new government initiative), with relationships/correlations amongst themselves and the global markets. On the horizon, look for a new brand of Real Options modeling which overcome all of these drawbacks and hurdles. For the companies that have tried them, these models have increased simplicity and understanding, and have helped these companies create significant value through strategies (e.g., routinely a 30% increase in NPV or 30% decrease in costs in a cost-only model when compared to their traditional ROI analysis strategies with the NPV measured in the full information model).

Posted by Mark Erickson on May 05, 2010 at 07:20 AM PDT #

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