Innovator’s Dilemmas: real options in R&D? (3)
“Traditional valuation techniques often fail to capture or adequately quantify the value created by technology initiatives (…) Anyone who has tried to measure the value of a technology investment has, at some point, discovered the difficulty of presenting a compelling business case using standard techniques like net present value (NPV) or return on investment (ROI).”
“Projected cash flows seem meager in comparison to the investment required, or the discount rate chosen to compensate for the risk is so high that it renders the NPV unpalatable. Analysts often resort to instinctive appeals of “synergy,” “table stakes” or “strategic importance” to compensate for the valuation shortfall.”
Read Dan Latimore’s paper, “Calculating value during uncertainty: Getting real with real options”, published by IBM Institute of Business Value.
“Option pricing methods are superior to traditional DCF approaches because they explicitly capture the value of flexibility. As a result, we believe that option-pricing techniques will eventually replace traditional DCF methods for investment decision where there is significant future flexibility. It is not clear that option pricing will replace DCF techniques for valuing whole companies except in limited circumstances.”
Read Tom Copeland, Tim Koller and Jack Murrin’s book, “Valuation. Measuring and Managing the Value of Companies“, published by McKinsey and Wiley.
Karen Berman and Joe Knight’s book, “Financial Intelligence”, clearly states that finance is one of those things which happen to be as much art as they are science.
When working on emerging technology projects, business modeling aims to deliver pro forma statements, helping teams discuss variables related to the underlying trends, value based pricing, subsequent cost targets, internal and external dependencies, as well as the product’s specific contribution to the value chain (e.g. percentage of value captured in the ecosystem).
This means developing quantitative views and qualitative insights focusing on how the company’s investment could theoretically perform over a given time frame.
This is key to business case reviews and is often based on limited data and an implicit understanding that any projections rely on assumptions and educated guesses (which should be spelled out anyway) because many innovations deal with uncharted territories.
Most would agree that it is best to work with short term estimates (e.g. 1+ years) supported by early market signals (as they might not have yet become market trends as such) and that any calculations beyond that (2+ years) become an exercise in numerology, a divinatory art in other words.
As an example, at a conference I recently attended in New York, some entrepreneurs leading well known web 2.0 firms mentioned that it is hard for them to figure out what’s going to happen to their business by the end of this year. Some VCs even question if you really need financial modeling to be able to make the kind of investment decisions they thrive in. I would refer you to another post from July of last year on innovator’s dilemmas to explore the rationale behind that statement a bit further.
As shared just yesterday, we are discussing projects characterized by high return / high risk scenarios, which might involve a longer investment commitment than less uncertain projects driven by better known customer demand and proven market trends. When looking at a company’s product portfolio, it is a well known fact that Net Present Value (NPV) and other discounted cash flow (DCF) would factor the project’s risky nature, but they might not capture the potential for value generation derived from the new technology.
As a result, flexibility (enabling the company’s actual options to innovate) is ignored and undervalued. DCF considers uncertainty as a negative factor, leading to a lower project valuation by applying high discount rates. This means: as the hurdle rate increases NPV decreases leading to decisions that can jeopardize long term opportunities, a mind bugging approach when the upside potential can be huge.
“For several years, the oil and gas industry and pharmaceutical companies— businesses characterized by large capital investments with extremely volatile payoffs—have been using real options to help them quantify the risks and potential rewards associated with making investments in risky environments.” Dan Latimore.
Just a quick reminder. I’m basing this discussion on the need for high tech companies to become serial innovators to sustain and grow their business vs. just relying on revenues from a flagship product and incremental innovation. By the way, I’m assuming this stuff is of interest as yesterday’s blog traffic was the highest recorded by consultaglobal so far.
Picture credits: Digital image content © 1997-2007 Hemera Technologies Inc., a wholly owned subsidiary of Jupiter Images Corporation. All Rights Reserved.
| J. de Francisco |  |
|
| Chicago, 1 May 08 |  |
 |
|
