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Operations Management Best Practice

Using Decision Analysis to Value R&D Projects

by Bert De Reyck

Executive Summary

  • Valuing R&D projects is a critical component of project portfolio management.

  • Traditional methods for valuing financial assets cannot be easily used for valuing R&D projects, as they are very different in nature.

  • Decision analysis is widely used for valuing projects in R&D-intensive industries such as pharmaceuticals and energy.

  • Using decision trees, one can determine a project’s expected net present value (eNPV) and downside risk, two essential ingredients for determining whether or not to proceed with the project.

 

Introduction

Project portfolio management, the equivalent of financial portfolio management but focused on R&D projects rather than financial assets, often relies on decision analysis methods to value projects rather than traditional financial valuation methods such as net present value (NPV). In finance, the idea of managing portfolios of assets goes back a long time, with the first formal methods being developed in the 1950s. Simply put, assembling a portfolio of stocks, bonds, and other financial instruments balances the risk a manager is taking with any one of the investments. Over time, this same idea has also taken hold for managing a portfolio of R&D projects, where it is referred to as project portfolio management.

Project portfolio management considers the company’s set of projects in a holistic way, providing an overview of the potential value, as well as the inherent risks of both the projects a company is currently engaged in and those it plans to initiate in the future. By means of project portfolio management, risks can be reduced through diversification of the product portfolio and value enhanced by identifying synergies between projects. Companies in the pharmaceutical and energy industries, for instance, have long recognized the value of project portfolio management, and they are using sophisticated methods and software tools to support this process.

Project portfolio management comprises the following functions:1

  • determine a viable project mix;

  • balance the portfolio;

  • monitor the projects in the portfolio;

  • analyze and enhance project performance;

  • evaluate new opportunities against the current portfolio, taking into account capacity and funding capabilities;

  • provide information and recommendations to decision-makers.

The Difference between Financial and R&D Portfolio Management

Financial portfolios and project portfolios are very different in nature. The main characteristics of investing in financial instruments include:

Divisible investments: Financial instruments allow investment in small portions of an asset, rather than being all or nothing.

Simple interdependencies: The interrelationships between different investment opportunities can typically be captured by: The correlation between the assets’ returns; and their financial value, as established by the financial markets.

Passive participation: Investing in financial instruments is typically a passive form of participation: The decision is mainly whether or not to invest, and how much.

Availability of information: Much information is available about financial assets in the form of historical performance and fundamental analyses concerning the future outlook.

Tradability: Most financial instruments are tradable assets, resulting in agreed-on valuations and opportunities to sell assets that do not fit your portfolio.

Clear objectives: The main objective is to maximize the risk–return performance of your portfolio.

Contractual clarity: Clearly defined terms exist for investing in a financial instrument, outlining the rights of the parties involved relying on established market rules.

These characteristics are not shared by a portfolio of R&D projects, which can be characterized as follows:

Discrete investments: Investments in projects are nondivisible, increasing the impact of an investment decision on your portfolio.

Complex interdependencies: Complex interdependencies and interactions exist between projects. Project outcomes are subject to synergies—for example, through the sharing of proprietary knowledge—and investment decisions may affect the options available in related projects.

Active participation: Investing in projects requires active management. Besides making a go/no-go decision and setting a budget, numerous decisions will have to be made during the project lifetime that will impact the outcome.

Lack of information: Since projects are largely unique, not much information is available on related past projects or for the prediction of future performance.

Nontradability: Projects cannot be easily sold, resulting in a lack of valuation information and lock-in situations.

Fuzzy objectives: Projects are typically governed by a multitude of objectives, both financial and nonfinancial, and typically include qualitative objectives.

Contract ambiguity: Project investments may result in disagreement concerning who is entitled to which benefit, with multiple stakeholders holding different views.

As a result, conclusions derived from finance cannot simply be transferred to other areas, nor can their methods be used without adaptation. That is why a variety of approaches have been proposed for valuing R&D projects, which is the central issue in managing a portfolio of R&D projects. The most commonly used is decision analysis, in which decision trees are used to represent the project’s potential outcomes and their likelihood.

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Further reading

Books:

  • Savage, Sam L. Decision Making with Insight. 2nd ed. Cincinnati, OH: South-Western College Publishing, 2003.
  • Winston, Wayne L., and S. Christian Albright. Practical Management Science. 3rd ed. Cincinnati, OH: South-Western College Publishing, 2006.

Websites:

  • Decision Analysis Society, a subdivision of the Institute for Operations Research and Management Science (INFORMS): decision-analysis.society.informs.org
  • Palisade Corporation, a provider of decision-analysis software, used to create the examples in this article: www.palisade.com
  • Strategic Decisions Group, a strategy consulting firm specializing in decision analysis and founded by, among others, the father of decision analysis, Professor Ronald A. Howard of Stanford University: www.sdg.com

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