Monday, June 05, 2006

The NPV Trap

Sorry, no link, but the FT ran an article last week on "valuing innovation" that gets right to one fundamental problem with financial analysis - its usefulness varies greatly depending on the maturity of the project. The article focuses on investment decisions in projects and R&D, but the thesis works just as well with M&A.

Probably because I come from a non-financial background, I've always nursed a little rebellious streak when it comes to financial analysis and the pedestal upon which NPV calculations are placed in the corporate world. Sure, I'll use them as much as the next guy, and I am a firm believer that a discounted cash flow analysis is the single best way to assess the value of an operating business. The problem is that such analyses are only as good as the assumptions that go into them.

While future results for mature operations can be estimated with a fair bit of accuracy (or at least conformed to the acquirer's 10 year planning assumptions for modeling purposes), trying to produce a similar DCF model for a 6-person start-up with wonderful but untested technology is an exercise in fiction writing. Yet - who hasn't seen someone trot out an NPV analysis and hold it up as objective truth, despite the fact that the assumptions underlying the analysis might as well have been plucked from a hat?

There can be a powerful tendency to try and view all potential investment via the same lens, and NPV analysis often gets a halo of legitimancy because it is numbers-driven. Sadly, the numbers that come out are no better than the assumptions that go in. The FT article thesis is that companies should use multiple scoring factors in evaluating projects, with greater weight given to financial analysis as the project gets more mature (and hence more amenable to accurate forecasting). In the case of acquisitions, companies need to weigh factors other than just the NPV analysis - strategic fit, customer needs addressed, people issues, scope of potential benefit, etc. Equally important, the NPV analysis should be known for what it is - a very useful tool under the right conditions, but one of diminishing usefulness when it comes to the new and different.

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