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Real Options

10 December, 2015 - 14:38

Amazon was incorporated in July of 1994. 1 Amazon reported its first-ever profits of $5 million (a penny a share at a $12.60 closing price) in the fourth quarter 2001 over 7 years after selling its first book. 2 I doubt that most investors using net present value (NPV) and internal rate of return (IRR) analysis would have been willing to wait so long to receive such a modest return. Profits in the fourth quarter of 2009 were $384 million (85 cents a share). 3 As Jeff Bezos noted in his articulation of Amazon’s strategy:

We start with the customer and we work backward. We learn whatever skills we need to service the customer. We build whatever technology we need to service the customer. The second thing is, we are inventors, so you won’t see us focusing on “me too” areas. We like to go down unexplored alleys and see what’s at the end. Sometimes they’re dead ends. Sometimes they open up into broad avenues and we find something really exciting. And then the third thing is, we’re willing to be long-term-oriented, which I think is one of the rarest characteristics. 4

NPV, IRR, and payback approaches may not be suitable for pursuing projects that will provide a competitive edge. The benefits of new technologies sometimes result in very strange NPV calculations that are either very high or very low. They are difficult to apply in situations involving emerging technologies where some level of investment is required in order to examine their long-run potential. There are inherent difficulties in data collection, decision analysis, and risk assessment when new and emerging technologies are involved. To put it bluntly, it is very difficult to apply discounted cash flow techniques for analyzing Blue Ocean markets. Real options can play an important role in developing a diversified product and technology portfolio for competing in dynamic environments.