Valuation methods in Project Portfolio Optimization - Focus on Real Options

From apppm
(Difference between revisions)
Jump to: navigation, search
Line 73: Line 73:
  
 
The project NPV (Net Present Value) can be calculated very simply <ref> Kodukula P., Papudesu, C. (2006) Project Valuation Using Real Options: A Practitioner's Guide, J. Ross Publishing </ref>:
 
The project NPV (Net Present Value) can be calculated very simply <ref> Kodukula P., Papudesu, C. (2006) Project Valuation Using Real Options: A Practitioner's Guide, J. Ross Publishing </ref>:
−
: <math> \text{Project NPV} = \text{PV of free cash flow in production phase} - \text{PV of investment cost} </math>
+
 
 +
Project NPV} = PV of free cash flow in production phase - PV of investment cost
 +
 
 
where PV stands for Present Value, and is calculated as follows:
 
where PV stands for Present Value, and is calculated as follows:
 
: <math> \text{PV} = \frac{\text{FV}}{\left(1+r\right)^n} </math> in discrete time, or
 
: <math> \text{PV} = \frac{\text{FV}}{\left(1+r\right)^n} </math> in discrete time, or

Revision as of 20:50, 16 September 2016

Contents

Abstract

Valuation methods are critical supporting tools for any decision in Project Portfolio Management, so as to optimize the project portfolio in terms of expected return for the different values (e.g. money, knowledge, strategic alignment). This article quickly presents general valuation techniques for generic portfolio management (NPV, DCF, see below), but might be more relevant as applied to R&D portfolio selection and optimization.

A project portfolio is optimized by evaluating a multi-objective ranking based on (1) the expected return, (2) the uncertainty, and (3) the strategic fit, while optimizing several budgets allocation:

  • Financial budget,
  • Technological or knowledge-based budget,
  • Budget based on the market uncertainty
  • Critical resources allocation budget

R&D portfolios optimization is based on project valuation, and an alternative to classical methods such as NPV (Net Present Valuation) and DCF (Discounted Cash Flow) is the real options valuation.

The core principle is similar to the principle of financial options: holding a decision which is to be made is equivalent to have an option, which can be valued. The only difference is the materiality of the option (‘real’), as opposed to the abstract nature of a financial option.

The real option valuation is based on a mixed set of input data, balanced between the expected return, the expected consumed resources and the different risk factors.




Project Portfolio Optimization in short

Project Portfolio Optimization in short (PPO) [1] Success of a PP = achievement of a sustainable competitive advantage Difficulties - projects may have conflicts in objective. Objectives can be hard to compare, align or match, some are tangible and others intangible[2] - uncertainties associated with project parameters, costs and risks[3] - some projects are highly interdependent [4] Two main factors leading to failure of portfolio to contribute to the implementation of the chosen strategy. First, implementing too many projects, beyond the capacities and abilities of the organization [5] [6] [7] [8] [9] [10] [11]

Then, satisfy short-term exigencies may ruin long-term success. Taking a decision and choosing a project implies to tie resource, which may be critical, to this project. Making this decision without considering the opportunity costs may lead to refuse a truly good opportunity or prospect in the future because of lack of resources, the necessary resources to pursue it being tied up in marginal undertakings [12] [13][14][15]

Importance to consider a portfolio as more than the simple collection of several project, as some projects may have interdependences [16] , generally in the areas of limited resources consumption, risk balancing and strategy alignment.



Selection and prioritization

Main criteria [17] [18] [19] [20] [21] - alignment with corporate strategy (corporate strategy must be reflected in the project composition of the portfolio and in the resource allocation to projects within the portfolio) - maximizing the value (financial, with metrics such as NPV or ROI, or broader, though weighted scored models for instance) - balancing, particularly balancing risk and return, long and short terms benefits, time to completion. PPM is the “bridge between strategy and operations” [22] [23]


Basic presentation of classical valuation methods, for single projects

The classical methods for evaluating projects are often DCF-based (Discounted Cash Flow), such as the classical NPV (Net Present Value) formulas. The following metrics can also be used: the IRR (internal return rate), ROI (Return Over Investment), ECV (expected commercial value), EV (Earned Value).

The project NPV (Net Present Value) can be calculated very simply [24]:

Project NPV} = PV of free cash flow in production phase - PV of investment cost

where PV stands for Present Value, and is calculated as follows:

\text{PV} = \frac{\text{FV}}{\left(1+r\right)^n} in discrete time, or
\text{PV} = \text{FV}*e^{-r*t} in continuous time,

where FV is the future value of the cost (its estimate, or expectation), r the discount rate, n the number of (discrete) time periods between the future estimation and the present date, and t the amount of (continous) time between the future estimation and the present date.


Determination of ECV by Cooper, Edgett and Kleinschmidt[25]


Src: doc portfolio management –eve

But these models can underrate some projects, particularly the riskier ones, in dynamic and fast-changing environment [26] . Especially for R&D project portfolios, these methods might induce 2 main kinds of errors [27]

- Ignorance of the management flexibility, assumption of static cash flow. Does not take into account the possibility to interrupt a project to avoid more losses, for instance in case of technical failure (for instance tests failure, or other technical risks) or any economic risk, such as negative market variations. - Assumption that risk can only decrease the project value





Real Options for projects portfolios

Diagram, tomato garden – cf book et ref book The aim of the real options approach for project selection in PPO is to ensure that the right projects are selected, with the right scope and at the right time, whereas the ‘not right enough’ projects are kept in nurturing until having reached their full potential to become a candidate for the portfolio value and entering the portfolio pipeline (i.e. projects being in development) [28]

The Tomato Garden of Luerhman (Src: HBR)
Illustration of a R&D pipeline (Src: [29])




Real Options Valuation, a simplified model

From finance to projects

The equivalence from Finanial Options to Real Options is done through the translation of the input variables, according to the following table

Equivalences of input variables between Financial Options and Real Options (Enea, G. & Lo Nigro, G. (2011) [30] )
Input Variable Financial option Real option
S

Underlying asset value

Present value of the project expected incomes

X

Exercise price

Present value of the project investment costs

T

Time to maturity

Length of time in which the investment opportunity exists

\sigma

Volatility of returns on stock

Volatility of project cash flows

r

Riskless interest rate

Riskless interest rate


5 main kinds of real options [31]

- Growth option, by adding new products or knowledge (R&D) to the portfolio or the project - Abandon option, which is the option to abandon at any stage of the project - Defer and wait, to reduce uncertainty - Contraction, meaning temporary or permanently suspending - Switch or transition option, for instance changing the product mix (output mix), or the resource mix (input mix)

Generally, the decision to put a research project in a portfolio can be considered as a growth option, which is equivalent to a financial call option [32] . The necessary input values can be selected as follows, based on the work of Merck mentioned in Enea, G. & Lo Nigro, G. (2011) [33]

- Underlying asset value: expected present value of the cash flows deriving from the commercialization of equivalent products - Exercise price: investment cost at the launch of the project (for instance facilities investment, patent exploitation licenses cost, start-up cost) - Time to expiration: expected completion time of the project - Volatility: for instance, standard deviation of the annual revenues for the concerned industry


This kind of option can be modeled in a closed form, with the Black & Scholes formula for instance [34] . As mentioned previously, it is important to consider a research portfolio, and more generally a projects portfolio, as a whole and not only as a collection of individual projects, as there may be interdependencies. Therefore, the modelling of a portfolio is more likely to be done through a compound option, whose value can be estimated with a Geske model. A stochastic optimization model called OptFolio has been developed by Roger & Al [35] and simplified by Enea, G. & Lo Nigro, G. (2011) [36] into a model called OptFolio Light, which is presented below. The OptFolio maximizes the overall Real Options Value (ROV) of the portfolio, aiming at identifying the most valuable projects among the whole R&D projects portfolio of a company. It therefore can be used to select the best candidates from a set of R&D projects, those to be injected into the portfolio pipeline. In the original OptFolio, each R&D project process is modeled as a sequence of continuation/abandon (“go/kill”), with these decisions being taken at the beginning of each development phase of the project. Therefore, this is equivalent to financial Bermuda options, which are potions that can only be exercised on predetermined dates. In order to reduce the complexity of the model in OptFolio Light, Enea, G. & Lo Nigro, G. modeled the R&D process as a growth option instead of abandon, or as a sequence of growth options, depending on the number of development phases in the project. The simplified model also assumes that if a project is interrupted at any phase, it is dismissed from the optimal portfolio.

OptFolio Light model

Sets and variables

  • Product: i \in [\![1;P]\!]
  • Stage of project development: s \in [\![1;S]\!]
  • Date, within the maximum time horizon T: t \in [\![1;T]\!]

Parameters:

  • V_{0,i} = current value of project i (at t=0 )
  • \sigma_{i} = estimated market volatility for project i
  • r = risk-free interest rate
  • T_{i,s} = length of stage s for project i
  • I_{i,s} = investment cost of stage s for project i
  • \Phi_{i,s} = probability of technical success of stage s for project i
  • B_t = budget constraint at date t (for instance if the time scale is in year, B_t is the budget for year t )
  • C_i = real options value of project i
  • F_i = annual cash flow brought by project i
  • r_ind = rate of return in the concerned industry
  • n_i = expected duration of commercialization of the output of the project i
  • X_{i}^{R\&D} = percentage of cash flows of project i invested in R&D
  • F'_i = amount of annual cash flow of project i invested in R&D


The real option value of project i can be calculated accordingly to the number of development stages [37]

Number of development stages Corresponding formula
1 stage of development

Simple investment decision, therefore:

C_i = NCV_i
2 stages of development

Black and Scholes formula:

C_i = V_{0,i}*N(d_{1,i})-I_{i,2}*e^{-r T_{i,1}}*N(d_{2,i})

where:

d_{1,i} = \frac{ln(\frac{V_{0,i}}{I_{i,2} e^{-r T_{i,1}}})}{\sigma_{i} \sqrt{T_{i,1}}}+\frac{\sigma_{i} \sqrt{T_{i,1}}}{2}
d_{2,i} = d_{1,i} - \sigma_{i} \sqrt{T_{i,1}}
N is the cumulative normal distribution function
3 stages of development

Traditional Geske formula (see [38])

4 or more stages

Extended Geske model, developed by Cassimon & Al (see [39])

The value of the uniform cashflow F_i resulting from project i during n years is calculated with:

F_i = V_{0,i} \frac{\left(1+r_{ind} \right)^n r_{ind}}{\left(1+r_{ind} \right)^n -1} from which only a share <math> X_{i}^{R\&D} is reinvested in R&D, therefore:
F'_i = X_{i}^{R\&D} F_i

The decision variables are:

  • y_i , binary variable which is equal to 1 if the project i is selected in the portfolio, 0 otherwise;
  • z_i , binary variable which is equal to 1 if part of the cashflow of the project i is reinvested in R&D, 0 otherwise; therefore we have a natural constraint z_i \leq y_i appearing, by definition of the variables.
  • X_{i}^{R\&D} , a continous variable belonging [0;1] and representing the percentage of cash flows of project i invested in R&D. Samely, by definition, we have 0 \leq X_{i}^{R\&D} \leq 1

One more constraint is needed, the budget allocation one:

\sum_{i,s}{I_{i,s}\Phi_{i,s-1} y_i w_{i,s,t}} - \sum_{i}{w_{i,t} F'_i z_i w_{i,s,t}} \leq B_t


Finally, the complete OptFolio Light model formulation is:

\max \text{ROV} = \sum_{i}{\left(C_i - I_{i,1}\right)y_i} - \sum{i,t}{\frac{w_{i,t} F'_i z_i}{\left(1+r_{ind}\right)^t}}

s.t.

\sum_{i,s}{I_{i,s}\Phi_{i,s-1} y_i w_{i,s,t}} - \sum_{i}{w_{i,t} F'_i z_i w_{i,s,t}} \leq B_t
z_i \leq y_i
0 \leq X_{i}^{R\&D} \leq 1
y_{i}, z_{i} \in \{0;1\} ; X_{i}^{R\&D} \geq 0

Note on indexing: there is a lag between the decision and its effect, therefore decision in present time ( t=0 ) will influence the first development stage ( s=1 ), and identically for the following decisions and stages.

Extensions

- Fuzzy models - Sensivity analysis (directly reference the two articles on sensivity analysis)

Vocabulary

opportunity cost real option

C_i = V_{0,i}*N(d_{1,i})-I_{i,2}*e^{-r T_{i,1}}*N(d_{2,i}


Annotated Bibliography

Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE A thesis based on a case study in Vietnam, giving a good overview on Project Portfolio management goals, methods and techniques.

Enea, G. & Lo Nigro, G. (2011), A Real Options Based Model To Select a Balanced R&D Portfolio, University of Palermo and Geske, R. (1979); The Valuation of Compound Options. Journal of Financial Economics 7 (1979) 63-81. The two main documents of work for mathematical aspects.

Strategy as Portfolio of Real Options, Luehrman


Kodukula P., Papudesu, C. (2006) Project Valuation Using Real Options: A Practitioner's Guide, J. Ross Publishing

References

  1. ↑ Dietrich, P. & Lehtonen, P. (2005). Successful Management of Strategic Intensions through Multiple Projects - Reflections from Empirical Study. International Journal of Project Management, 23 (5), 386-391. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  2. ↑ Ghasemzadeh, F. & Archer, N. P. (2000). Project Portfolio Selection through Decision Support. Decision Support Systems, 29 (1), 73-88. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  3. ↑ Radulescu, Z. & Radulescu, M. (2001). ‘Project Portfolio Selection Models and Decision Support’, Research Paper, National Institute for Research & Development in Informatics, Romania Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  4. ↑ Ghasemzadeh, F.; Archer, N. and Iyogun, P. (1999). A Zero-One Model for Project Portfolio Selection and Scheduling. The Journal of the Operational Research Society, 50 (7), 745-755. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  5. ↑ Wheelwright, S. C. & Clark, K. B. (1992). Creating Project Plans to Focus Product Development. Harvard Business Review, 70 (2), 70-82. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  6. ↑ Archer, N.P. and Ghasemzadeh, F. (1999). An Integrated Framework for Project Portfolio Selection. International Journal of Project Management, 17 (4), 207-216. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  7. ↑ Englund, R. L. & Graham, R. J. (1999). From Experience: Linking Projects to Strategy. Journal of Production and Innovation Management, 16 (1), 52-64. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  8. ↑ Cooper, R. G., Edgett, S. J., & Kleinschmidt, E. J. (2000). New Problems, New Solutions: Making Portfolio Management More Effective. Research Technology Management, 43 (2), 18-33. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  9. ↑ Yelin, K. C. (2005). Linking Strategy and Project Portfolio Management. In Levine, H. A. (eds.) (2005) Project Portfolio Management: A practical guide to selecting projects, managing portfolios and maximizing benefit, pp. 137- 145. USA: Pfeiffer Wiley. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  10. ↑ Crawford, L.; Hobbs, B. & Turner, J.R. (2006). Aligning Capability with Strategy: Categorizing Projects to Do the Right Projects and to Do Them Right. Project Management Journal, 37 (2), 38-50. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  11. ↑ Blichfeldt, B. S. & Eskerod, P. (2007). Project Portfolio Management - There’s More to It than What Management Enacts. International Journal of Project Management, in press, corrected proof. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  12. ↑ Frame, J. D. (1994). Selecting Projects that Will Lead to Success. Reprinted in: Dye, L. D. & Pennypacker, J. S. (eds). (1999) Project Portfolio Management: Selecting and Prioritizing Projects for Competitive Advantage, pp.169-181, Critical point is resource allocation, as finite resource available. Therefore, crucial to wisely allocate resources, especially strategic ones, to support the corporate strategy.
  13. ↑ Porter, M. E. (1985). Competitive Advantage. New York, USA: The Free Press. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  14. ↑ Johnson, G., Scholes, K. & Whittington, R. (2006). ‘Exploring Corporate Strategy’. 7th ed. Harlow, Essex: Pearson Education Limited. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  15. ↑ Johnson, G., Scholes, K. & Whittington, R. (2006). ‘Exploring Corporate Strategy’. 7th ed. Harlow, Essex: Pearson Education Limited. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  16. ↑ Enea, G. & Lo Nigro, G. (2011), A Real Options Based Model To Select a Balanced R&D Portfolio, University of Palermo
  17. ↑ Sommer, R. J. (1999). Portfolio Management for Projects: A New Paradigm. In Dye, L.D. and Pennypacker, J.S. (eds.) (1999) Project Portfolio Management: Selecting and Prioritizing Projects for Competitive Advantage, pp. 55-60. West Chester, PA: Center for Business Practices. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  18. ↑ Archer, N.P. and Ghasemzadeh, F. (1999). An Integrated Framework for Project Portfolio Selection. International Journal of Project Management, 17 (4), 207-216. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  19. ↑ Radulescu, Z. & Radulescu, M. (2001). ‘Project Portfolio Selection Models and Decision Support’, Research Paper, National Institute for Research & Development in Informatics, Romania Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  20. ↑ Ghasemzadeh, F.; Archer, N. and Iyogun, P. (1999). A Zero-One Model for Project Portfolio Selection and Scheduling. The Journal of the Operational Research Society, 50 (7), 745-755. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  21. ↑ Yelin, K. C. (2005). Linking Strategy and Project Portfolio Management. In Levine, H. A. (eds.) (2005) Project Portfolio Management: A practical guide to selecting projects, managing portfolios and maximizing benefit, pp. 137- 145. USA: Pfeiffer Wiley. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  22. ↑ Morris, P. & Jamieson, A. (2004). Translating Corporate Strategy into Project Strategy: Realizing Corporate Strategy through Project Management. USA: PMI. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  23. ↑ Dey, P. K. (2006). Integrated Project Evaluation and Selection Using Multiple- Attribute Decision-Making Technique. International Journal of Production Economics, 103 (1), 90-103. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  24. ↑ Kodukula P., Papudesu, C. (2006) Project Valuation Using Real Options: A Practitioner's Guide, J. Ross Publishing
  25. ↑ Cooper R., Edgett, S. and Kleinschmidt, E. (2011), Portfolio Management: Fundamental for New Product Success
  26. ↑ Enea, G. & Lo Nigro, G. (2011), A Real Options Based Model To Select a Balanced R&D Portfolio, University of Palermo
  27. ↑ Enea, G. & Lo Nigro, G. (2011), A Real Options Based Model To Select a Balanced R&D Portfolio, University of Palermo
  28. ↑ Gardiner, P. D and Carden, J. (2004). The “Benefit Pipeline” Approach to the Strategic Implementation of Projects. IRNOP VI Conference, Turku, Finland. Via Cao Le, M. & Tau Nguyen, V. (2007), Strategy for Project Portfolio Selection in Private Corportations in Vietnam, Master Thesis USBE
  29. ↑ [1]
  30. ↑ Enea, G. & Lo Nigro, G. (2011), A Real Options Based Model To Select a Balanced R&D Portfolio, University of Palermo
  31. ↑ Enea, G. & Lo Nigro, G. (2011), A Real Options Based Model To Select a Balanced R&D Portfolio, University of Palermo
  32. ↑ Enea, G. & Lo Nigro, G. (2011), A Real Options Based Model To Select a Balanced R&D Portfolio, University of Palermo
  33. ↑ Enea, G. & Lo Nigro, G. (2011), A Real Options Based Model To Select a Balanced R&D Portfolio, University of Palermo
  34. ↑ Enea, G. & Lo Nigro, G. (2011), A Real Options Based Model To Select a Balanced R&D Portfolio, University of Palermo
  35. ↑ Rogers, M. J., Gupta, Maranas, C. D. (2002); Real options based analysis of optimal pharmaceutical research and development portfolios Ind. Eng. Chem. Res. 2002, 41, 6607-6620 Via Enea, G. & Lo Nigro, G. (2011), A Real Options Based Model To Select a Balanced R&D Portfolio, University of Palermo
  36. ↑ Enea, G. & Lo Nigro, G. (2011), A Real Options Based Model To Select a Balanced R&D Portfolio, University of Palermo
  37. ↑ Enea, G. & Lo Nigro, G. (2011), A Real Options Based Model To Select a Balanced R&D Portfolio, University of Palermo
  38. ↑ Geske, R. (1979); The Valuation of Compound Options. Journal of Financial Economics 7 (1979) 63-81.
  39. ↑ Cassimon, D, Engelen, P. J., Thomassen, L., Van Wouwe, M. (2004); The valuation of a NDA using a 6-fold compound option. Research Policy 33: 41–51 Via Enea, G. & Lo Nigro, G. (2011), A Real Options Based Model To Select a Balanced R&D Portfolio, University of Palermo
Retrieved from "http://wiki.doing-projects.org/index.php?title=Valuation_methods_in_Project_Portfolio_Optimization_-_Focus_on_Real_Options&oldid=24868"
Personal tools
Namespaces

Variants
Actions
Navigation
Toolbox