Customer Collaboration What’s a Sustainable Competitive Advantage, and how do I get one?
Nov 112009

Business schools teach that the best measure of the value of a business is the cash that’s generated by the business. This is usually defined as the net present value (NPV), or the current value of the cash flow the business will generate in the future. So according to the textbooks, selecting between strategic options is easy. You simply pick the one that generates the highest NPV, because that’s the one that maximizes the value of the business. But here’s the problem – We don’t know for sure the cash flow the business will generate in the future, because we don’t know for sure what the future will look like.

Which way

That’s why it’s important to understand risk and uncertainty, and to test strategies against alternative views of the future.

A detailed, robust financial model based in Excel or some other spreadsheet or financial software is a valuable tool for evaluating strategic options and monitoring business performance. A well constructed model can allow you to isolate key business drivers and use statistical techniques to assess the relative risk of strategic options.

Let’s say you want to expand your plant, but there are too many factors you can’t predict to make you comfortable with the decision. The cost of steel and other materials has skyrocketed, and you’re worried about cost over-runs. You’re concerned about how your competition will respond, and worried that you may have to reduce prices to expand sales. You’re also concerned about rising fuel costs, because your key competitor is located in an oil producing country that regulates energy prices to support local industry, and you have to pay market prices. A plant expansion would improve fuel efficiency, but will it save enough to offset investment costs and potentially lower margins? You’ve had an analysis done based on your “best guess”, and both the expansion and non expansion options yield the same NPV.

The chart below is an example of a statistical tool that can help you make the decision.

Which way is the future

This is a “Cumulative Probability” chart that shows NPV calculations for each option based on a range of possible outcomes for major future uncertainties. In this case, the major uncertainties could include investment costs, energy costs, and margins. For each uncertainty the project team selects high, low and medium probability values, so that they are 90% confident that the actual outcome will fall within the selected range. So instead of making the strategic decision of whether or not to expand based on the best guess of one value for each key uncertainty, you can make your decision based on a range of possible outcomes that factor in the risk associated with all identified uncertainties. In this case, the red line shows that the “Expand” option has a 50% probability of yielding a better outcome than the “Don’t Expand” option. However, it has a 20% chance of yielding a negative NPV, or actually reducing the value of the business. The blue line shows that the “Don’t Expand” option yields a top end NPV about $50 MM below the “Expand” option. But it also has a 50% probability of yielding a better outcome than the “Expand” option. More importantly, it has a zero probability of yielding a negative NPV and destroying value. Which option would you choose?

To find out how we can help you with your strategic decision making give us a call at 832 748 1900.

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