Whether it’s because of technological changes, new competition or macroeconomic developments, increasingly organizations find themselves facing volatility in their markets. Novel, advanced approaches to valuation can help CFOs and other decision-makers to better evaluate their investment decisions in this dynamic environment, argues Paolo Fulghieri, Macon G. Patton Distinguished Professor of Finance at the Kenan-Flagler Business School of the University of North Carolina.
When faced with investment decisions, every CFO wants to have as much insight as possible into the potential risks and opportunities of a project or acquisition. Traditionally the way to evaluate investments has always been the Discounted Cash Flow model, DCF. Therefore, this is sometimes called ‘the workhorse’ of valuation. It takes all projected future cash flows and, applying the discount rate, calculates the Net Present Value of investment projects, or NPV. Similarly, the DCF is used in acquisitions to evaluate assets.
“We all understand that having the flexibility to respond to a changing economic environment is valuable. The question is how to translate the notion that this is valuable into dollars and cents.”Paolo Fulghieri, Professor of Finance University of North Carolina
Translating flexibility into dollars
However, DCF has a number of important limitations, says Fulghieri. Not the least of which is that it does not allow for strategic adjustments necessitated by unexpected developments in the future. “Down the road things may happen and management may have to make decisions that reflect that changing environment. You might want to scale up, scale down, refocus, or even abandon a project. Now, we all understand that having the flexibility to respond to a changing economic environment is valuable. The question is how to translate the notion that this is valuable into dollars and cents? In other words: how do you value today the fact that two or three years down the road you’ll have the ability to make a reassessment?”
Important to realize, Fulghieri stresses, is that there are two sides to volatility. On the one side there are the risks, on the other side there is the opportunity of upwards potential. In particular the upside is an aspect of volatility the DCF model is unable to capture. “The important thing is how to properly measure the upside potential. There will be projects that will not appear attractive when you assess them only with the standard DCF. You might be sitting on a valuable investment, yet you don’t recognize at all that this investment is valuable.”
He gives an example from the pharmaceutical industry. “Let’s say you have an investment opportunity to develop a patent for a new drug, and you need to commit a billion dollars. What are you going to do?” There are different sources of volatility, Fulghieri points out. There is the uncertainty whether a drug will get through the registration process.
Another element of uncertainty concerns future revenues from the drug, which may depend on the extent of health insurance reimbursements. These are dependent on factors such as the political and regulatory climate, as well as the state of the general economy. The events surrounding the development of COVID vaccines are an example of this. At the same time the capital commitment is phased, giving management flexibility.
In cases like these the simple DCF model is not of much use. An alternative approach is to apply scenario analysis. The concept is to make projections for future cash flows in different scenarios and then use these as input for a DCF model.
“This is a good first step”, says Fulghieri. However he adds that this approach also has its limitations. “As it turns out, DCF typically uses a constant discount rate, a constant cost of capital. Using this in the different scenarios will give an incorrect outcome and lead to misvaluations. Typically, in this case scenario analysis will overestimate the value of the upside. So while, you may underestimate the true value when you use the standard DCF, with scenario analysis, you may overestimate the true value.”
“You’ll recognize value propositions that you didn’t identify before, while preventing to go overboard and invest too much.”
To deal with these problems alternative approaches have been developed that blend together different techniques. An example is to combine DCF, Option analysis and Decision-risk modelling. This approach yields more accurate results, Fulghieri argues. “If you use these techniques, you can more properly measure the value of investment projects or assets. You reduce the risk of underinvesting or overinvesting, and improve your performance. You recognize value propositions that you didn’t identify before, while preventing to go overboard and invest too much.”
This gives executives charged with taking investment decisions more accurate insight into the true value implications of an investment. “Of course the CFO doesn’t need to know all the nitty gritty details of how we get there, but it allows the people who generate the analysis to very clearly present the value drivers, and value metrics. They are able to show both the upside potential as well as the downside risks that contributed to the valuation.”
These methods are useful in all environments where volatility is an issue and where firms must commit large capital investments, Fulghieri concludes. “It doesn’t matter where the variability is coming from. Of course, if it’s commodity-based it’s pretty obvious, just look at oil or gas prices today, but it could also be a disruption by a competitor, or a new technology. Any time there is a lot of uncertainty in the cash flow projections, and this uncertainty affects your investment strategy, these techniques can be fruitfully applied.”
Prof. Paolo Fulghieri teaches the programs Unlocking Value in Volatile Markets: An Advanced Valuation Program, Foundations of Finance and Initial Public Offerings at Amsterdam Institute of Finance. Learn more & reserve your place here.