Combining Scenarios and Real Options to Address Uncertainty in Strategy Formulation

The 21^st century business environment has even become more turbulent and uncertain, and therefore unpredictable. Every firm deals with uncertainty in its lifecycle. Uncertainty impedes the ability of management to make strategic decisions. There are many sources of uncertainty, but the most important ones are related to the firm’s external environment and black swan events. Scenario techniques can help to cope with uncertainties in making strategic decisions. Scenario analysis can be used to identify threats and opportunities, evaluate current strategies, generate new alternative strategies, build consensus, and develop flexible thinking. We can further evaluate the generated strategies under different scenarios to identify the most robust strategies. Historically, governments, businesses, and the military have used scenarios for a long time as a powerful tool to mitigate the consequences of uncertainty. However, due to the increased intensity of the uncertainty in the business environment in the past two decades, the effectiveness of scenarios has been reduced. Scenario techniques have been used in the past with other techniques, such as road mapping, Delphi, decision trees, and creativity to improve their effectiveness. However, scenario techniques can also be improved if we combine them with real option strategies. Both scenarios and real options strategies are tools used to make strategic decisions under uncertainty. Thus, scenarios focus on the external environment and real options focus on the internal environment to create value for the firm. However, using these tools separately can be less effective in combating uncertainty. Combining these tools can effectively minimize the overall strategic risk and enhance value creation. Moreover, during any sudden changes in the business environment, real options strategies become an important source of value creation for the firm.

Scenario Analysis or Scenario Planning

In developing strategic plans and managing strategic change, it becomes imperative to explicitly address and understand the strategic implications of uncertainty in more detail. Scenario analysis or scenario planning is a powerful tool to systematically identify and analyze the sources of uncertainty facing an industry or a firm and to convert them into useful scenarios. A scenario is a firm’s consistent view of how the future might unfold in light of current trends and uncertainties in the firm’s external environment. Since the 1970s, companies have been using scenarios to identify and mitigate the negative effect of uncertainties present in their system.

After identifying and defining the scenarios, we identify the risks and opportunities associated with each scenario and compare them with the baseline or current strategy or business plan. Next, we analyze each scenario with respect to industry structure, competitor behavior, and value creation potential based on the given assumptions. After developing multiple scenarios, the probable outcomes of each scenario are analyzed, and then the best outcomes are selected to formulate a strategy. In practice, most companies focus on generating scenarios and not on determining the impact of each scenario. Because there is also less published literature available on strategy formulation using scenarios, many companies find difficulties in converting the developed scenarios into strategy. Moreover, the industry scenario tool is not a complete tool to formulate strategies. Instead, in uncertain conditions, scenarios give the executives a framework for formulating strategy.

Scenarios are a useful tool to identify uncertainties in the firm’s industry environment, but their process is time-consuming. To make a decision-making process more effective, it should have the ability to create value, and therefore, generate profit for the firm in the long-run. To achieve this, the scenario tool is complemented by other tools to make it effective.

Real Options Strategies

In the world of uncertainty, the term option, a choice of whether to do something, has the potential to create firm value. In the past two decades, the field of real options analysis has emerged as a powerful tool to make investment decisions and formulating strategies. There are two types of real options strategies: growth options and flexibility options strategies. Growth options strategies permit us to make small investments in several new long-term opportunities projects without committing entirely to them. For example, Royal Dutch Shell has made small investments in joint-venture long-term development projects to produce hydrogen for fuel cell consumption. These low investment projects have the potential to generate high returns. Here, Shell has created an option by developing hydrogen fuel cell technology (by developing know how) and its intellectual property. Developing a strategy based on growth options includes investing in platforms, forming strategic alliances, and developing organizational capabilities.

• Platforms: by investing in platforms, a firm can develop core products or technologies that can further create several new business opportunities. When 3M invested in the nanotechnology platform, it offered the opportunity to develop new products in different areas, such as dental restoratives, image messaging services, and protective coatings.
• Strategic Alliances: A joint venture is a popular form of strategic alliance. A joint venture provides a platform for a firm with limited investment to create new businesses. Virgin group created many businesses using joint ventures.
• Organization Capabilities: A firm’s capabilities can be considered as options because they have the conditional ability to generate a competitive advantage across many products and businesses. Fujifilm’s thin-film coating capability has given it the option to diversify into multiple businesses, such as cosmetics, optical devices, industrial coating, and magnetic recording materials.

Flexibility options are related more to the functional strategies-the design of projects and plants to suit different conditions using portfolios, programs, and projects. For example, a flexible manufacturing program permits the manufacturing of different product models on the same production line. Projects can be designed to incorporate both growth and flexibility options. Moreover, in today’s uncertain business environment, all investments are at risk, but having flexibility can reduce the investment risk: if you lose, you lose little. Instead of committing entirely to a project-which involves substantial risk-breaking down the project into phases is advantageous. The phased approach creates an option whether to continue the project to the next phase, abandon it, delay it, or amend it.

Combining Scenarios with Real Option Strategies

We take a two-stage approach to dealing with the uncertainty a firm is facing. In the first stage, we develop and analyze a set of industry scenarios, and then convert and map these scenarios into appropriate hypothetical corporate strategies. A corporation’s corporate directional strategy comprises three strategies: growth, stability, and retrenchment. And typical scenarios include base-case, most likely, and worst-case scenarios. Therefore, a firm can choose growth for the best case, stability for the base case, and retrenchment strategy for the worst-case scenario should it occur. If a particular scenario occurs, then the relevant hypothetical corporate strategy as described above becomes real, which can then help to cope with the uncertainty in the first stage. An important feature of scenarios is to reveal the overall direction in which the firm should proceed should any scenario occur. For example, if a firm designs and selects a stability strategy-which means no changes to the current strategy and accepting the risk as it is.

In the second stage, we combine the corporate strategy with the real options strategy. The outputs from the hypothetical corporate strategy to follow and the underlying assumptions of scenarios become the inputs to design the options strategy. Here, the risk assumed in the first stage is considerably minimized by using the real options strategy. Real options strategy can create enterprise value by generating profits and creating real options.

In practice, most firms use the most likely scenario to formulate a strategy without any options strategy in place. In this situation, there is still a higher risk of designing a strategy around the most likely scenario because, if other scenarios emerge in the future that will make the strategy unsuitable, and therefore, it will be difficult to modify or reverse the strategy in-between the course. However, a real options strategy will produce satisfactory results when it is combined with any scenario. The options strategy has the potential to minimize the maximum loss as well as maximize the value creation potential of the firm in any scenario.

Using Scenario Assumptions in Financial Model Plans

One advantage of developing scenarios is that they transform implicit assumptions into explicit assumptions that help in reducing uncertainty. By using these explicit assumptions in the financial planning model assumptions, a firm can make effective strategic financial and investment decisions. In building the financial planning models, the model parameters-also known as value drivers include the major assumptions. The crucial phase in combining scenarios and real options is in converting the environmental factors into assumptions to influence the financial condition of the company. For example, if we consider a most likely scenario which points to a corporate strategy of stability, we make no changes to the firm’s current strategy and accept the risk whatever ever it may be. This points to a financial planning model with no changes to the current strategy’s financial planning assumptions. However, under this scenario, if we slightly vary the model’s assumptions, we can generate several flexible options to project the firm’s future financial performance and select the desired outcomes for implementation. Therefore, real options analysis, when performed based on assumptions derived from scenarios, is more effective in making investment decisions and reducing the environmental uncertainty of the system by reducing the risk.

References and Further Reading

1. M. Grant, Contemporary Strategy Analysis (United Kingdom: John Wiley & Sons, Ltd., 2018), Chapters 2, 8, and 15.
2. Mietzner, D. and Reger, G. (2005). Advantages and disadvantages of scenario approaches for strategic foresight,’ J. Technology Intelligence and Planning, Vol. 1, No. 2, pp.220–239.
3. G Favato, J A Cottingham, and N Isachenkova, “Blending Scenarios into Real Options: Relevance of the Pay-off Method to Management Investment Decisions.” Journal of Finance and Accounting, vol. 3, no. 2 (2015): 12-17. doi: 10.12691/jfa-3-2-1.
4. E. Porter, Competitive Advantage (N.Y., The Free Press, 1998), Chapter 13.
5. Karolina Daszyńska-Żygadło, Scenario planning and real options analysis in integrated risk management process, 6th International Scientific Conference Managing and Modelling of Financial Risks, VŠB-TU Ostrava, Faculty of Economics, Finance Department 10th–11th September 2012.
6. L. Wheelen & J. D. Hunger, Strategic Management & Business Policy (New Jersey: Prentice-Hall, 2000), Chapters 1 and 6.
7. Simon Benninga, Principles of Finance with Excel (New York: Oxford University Press, 2006), Chapter 10.