January 22, 2016 2 Comments
Woke up early this morning to the buzzing in my head…An idea that Options Theory as currently applied within more sophisticated enterprises for IT Investment was off the mark. I’d spent the past year going through application of approaches such as Black-Sholes which for external markets tracks well. However, for IT Investments there is something slightly askew. That uncomfortable feeling of what and how finally popped in my head this morning.
Several things about the standard approach to Investment Markets Options Theory rely upon market forces to determine value. However, within the Enterprise Ecosystem value is not measured by standard economics of buyer/seller in the traditional sense. Arbitrage in the market does not apply in the traditional sense. The investment is either exercised for its perceived utility or not; typically based and prioritized upon return on investment of the asset (in the broadest sense of the word asset). In corporations however there are two economic systems at play:
- External Ecosystem, the one in which the enterprise participates in. Here the economics that investment professionals typically discuss and where options theory approaches such as Black-Scholes apply. One can apply hedging as in Black-Scholes to capture the best Risk/Reward. Within this ecosystem market dynamics have investments flow between investment vehicles based upon perceived future value. With items other than perishable commodities the perceived value is not always inline with standard accounting practices. When valuation of corporations occur Intangible assets such as “Customer Good Will” and “Intellectual Property” are used as a filler to account for the difference between residual value of physical assets in general accounting practices (i.e., cadaver accounting) and investment accounting.
- Internal Ecosystem, a set of economics that is governed more strongly by general accounting practices; costs and benefits must somehow be in balance. However, a semi-closed system is assumed within such an economic system. That assumption is later adjusted each quarter or year by increasing an Intangible Asset valuation on the books. This ecosystem is driven by several factors: Asset Depreciation and Utility Value of Assets deployed.
These two economic systems interact through several interfaces of which not all are visible or easily measurable. Monetary funds go into the Internal Ecosystem from the External Ecosystem on the assumption that these funds will be used to purchase assets and through utilization of these assets return more or increase in value the enterprise. This in the external system takes the form of stock price or dividends. Which in many US based firms now provides a stronger drive to the internal dynamics of a publically held corporation.
However, the value of individual assets inside a corporation is not as simple as those in the external ecosystem. Inside the corporation assets are combined with a purpose in mind, to create a utility value. While the individual assets are accounted for in general accounting practices the utility value of a configuration of assets is typically not.
An example; a machine is purchased, a process developed to use it and others to create a product or service, supplies/consumables are also purchased, and people trained to create and sell the product / service. This creates some value if the product or service is consumed by the external ecosystem in exchange for revenue. Ten years later the internal assets have been depreciated in value to zero, yet the enterprise is still getting utility value from this configuration of assets. One year later a competitor’s product / service attracts enough consumers to make the enterprise’s offering unprofitable. The assets once providing utility value, though zero accounting value through depreciation, are now in negative territory. Now we’ll complicate things. One of the assets in the configuration was a computer. It can be reassigned to do other tasks thus extending its utility value in another configuration.
Thus the value of assets in an internal ecosystem’s portfolio needs to be managed differently. Those management practices need to more strongly account for internal utility value that it contributes within an hierarchy of abstract portfolios that support an enterprise’s participation in the various value streams in which it is a member. That insight realized this morning has been what has been driving me to revise the portfolio management practices I had defined for previous employers –though better than none– seem not adequate for the task. With that insight in mind developing the economic methods –for what I’ve called Level 5 Dynamic Management that are closer aligned to how an enterprise operates internally– appears more attainable and palatable than just inserting a standard Black-Scholes model.