Probabilistic Methods For Calculating IT Value: Real Options Valuation, Applied Information Economics

Real Options Valuation (ROV)

“What kind of investment do we make in technology to create flexibility?”

Nuts and Bolts: Taking its cue from the Nobel-prize-winning Black-Scholes model for valuing options, ROV aims to put a quantifiable value on flexibility. The technique was applied to leasing, mergers and acquisitions, and manufacturing. Around 1990, “it became a very natural question to say, What kind of investment do we make in technology to create that kind of flexibility?” says John Henderson, the Richard C. Shipley professor of management at Boston University and chairman of that department. Thus began the movement to value infrastructure and other ground-floor technologies, because nearly all other technical innovations are built on top of those base decisions.

Word of Mouth: Academic and arcane, but valuable. Works best as a stand-in for standard capital-budgeting processes in markets and economies where uncertainty is high and the need to stay flexible is at a premium. Most companies use ROV as a building block alongside more traditional financial and productivity measures.

Time and Money: Not applicable, as ROV is most often used as one measure inside a larger valuation plan.

Applied Information Economics (AIE)

“If we can compute probability on a satellite that’s never flown before, we can compute project success in IT.”

Nuts and Bolts: Here’s a method for people who mistrust TEI’s sliding-scale “guesstimation” of risk analysis, feel uncomfortable with TCO’s single-point outcomes, and wouldn’t use a Balanced Scorecard to take a nap on. If you’re looking for quantifiable, statistically valid risk-return analysis that would make an insurance executive drool, AIE should work.

AIE developer Douglas Hubbard combines options theory, modern portfolio theory, traditional accounting measures like NPV, ROI and IRR, and a raft of actuarial statistics to quantify uncertain outcomes and generate a bell curve of expected results that objectively incorporates both risk and return. “If we can compute probability on a satellite that’s never flown before, we can compute project success in IT,” Hubbard insists. “IT does have a repeatable history, and if you’re not willing to include that in your analysis, you may as well just flip a coin.”

Word of Mouth: This is the most numbers-heavy methodology covered here. Like the IT Scorecard, AIE is essentially a one-man show. Critics charge its myriad calculations eventually hit the law of diminishing returns. For costly and career-making projects, it’s a thorough and statistically valid way to analyze risk.

Time and Money: Plus or minus eight weeks; costs are typically 1 percent to 2 percent of overall project budget.