Thursday, January 03, 2008

On the Limits of Analysis

Ken Klee over at Corporate Dealmaker penned a brief review of a recent HBR article titled "Innovation Killers: How financial tools destroy your capacity to do new things." As Ken points out, any critique of the limitations of DCF analysis is highly applicable to dealmaking.

I've mentioned before my somewhat jaundiced view toward financial analysis and the reverence to which it is held in every big company I've worked with. While DCF analysis has its place, its limitations absolutely must be recognized.

As Ken points out, one problem is that fact that most DCF models are built on status quo assumptions (or corporate growth projections) that don't account for the strategic and competitive dimension. I would add that there is also the simple problem of garbage-in, garbage-out: the less you know about what's likely to happen (as is the case with new lines of business and transformational transactions), the less reliable the output of your DCF model becomes. The problem is that instead of acknowledging this limitation, many embrace the modeled output as Holy Writ. Besides being a false data crutch, it squeezes out consideration of other "softer" factors (like assumed competitive ramifications, or non-quantifiable synergies)that are every bit as worthy of consideration.

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