Making good decisions is important, both for our personal lives and for investments we want to make. Because the decisions we make today have a significant impact on our future, It is essential to start making better decisions now. For all those who are exploring ideas and considering what projects to invest in, I'll expand your way of decision-making, by adding another angle to the static techniques from corporate finance which are widely used.
Traditionally, we assess the attractiveness of an investment as a mature business, where future cash flows mainly result from past decisions. But, while past results and decisions are fixed, the future is wide open and even unpredictable. In addition, the project under consideration can be at a stage where there is still no business history and the current challenge is an R&D challenge, so how do you project from the past onto the future? Therefore, future decisions are highly influenced by uncertainty, competition, and future decisions. So, when you make a decision based only on the current situation, you might miss out on uncertain but promising opportunities. But if you are open to embrace uncertainty, explore opportunities and seize them, you can change your path and increase value.
To emphasize this, I'll introduce a better outlook of valuation. Instead of assessing future opportunities based on intuition and experience alone, I'll showcase the tools you need to assess the attractiveness of promising opportunities based on a structured and quantitative analysis. Since you may know that perspective affects our perception of reality, you can imagine how it deceives our judgment while making decisions. For example, during acquisitions, when we need to estimate the value of investments. So, accurately quantifying strategy is key in good decision-making. We have to change perspective and move from focusing on static discounted cash flow (DCF) valuation to the valuation of a complete strategies. Meaning that we need to see decisions not as isolated but as a part of a system of current and future interactions.
When valuing potential investments, you should not only look at their value today, but also assess which future growth opportunities they create. Namely, you can see all future investment decisions as interrelated links in a chain: what you decide now has an influence on your future. So, only when you value strategies instead of standalone projects, you get the complete picture of a potential investment's value. To value companies, their options, and complete strategies, I would like to propose the "Expanded Strategic NPV", which brings together the DCF, future options and games. The other two factors also include a significant component of risk assessment and mitigation.
The basic concept of value
When considering the attractiveness of business projects and its value, the reality can always be deceptive.
Especially when valuing potential investment or an M&A project, it is important to make correct estimations. In order to avoid misevaluation, or overvaluation, the Expanded Strategic NPV could serve great deal for decision making.
Company value is often based on traditional valuation methods of corporate finance, such as the DCF analysis. While this method works well when determining the present value of a company's existing assets, it explains merely a part of a company's total value. Besides knowing a company's value of assets currently in place, it is crucial to recognize the Present Value of Growth Opportunities (PVGO).
The PVGO is an omnipresent and often substantial component of a company's market value, especially in innovative firms in a continuously changing environment. The PVGO reflects a company's future options on real assets. For example, think of innovative companies that have heavily invested in R&D: they might not yet generate a positive cash flow, but they do have a high market value due to their growth options. Clearly, here, a static DCF analysis is not sufficient to capture the full market value of a company. Furthermore, we have to take into account that all future opportunities are vulnerable to rivals' actions. Therefore, we combine the DCF and real options approach with game theory. When you combine these three components of value, it all comes together in the expanded strategic present value.
This framework provides insight in: how is a company doing now? What are a company's future options? And, what might competitors do? Now that we know that PVGO can take up a large part of a company's market value, let's understand the value creation behind growth options: where does PVGO value come from? And why do some companies have valuable growth options and other companies simply not?
Let's embrace the uncertainty
There are people who simply unable to withstand and function in the face of uncertainty, and by making decisions, one might think that uncertainty is a bad thing. However, people miss out on the best opportunities in life because they're afraid to head into an uncertain direction. But in the end, we often regret the chances we didn't take. Therefore, I will help you embrace uncertainty with real options. I believe It's time to think differently about uncertainty. Investment decisions are not seen as a now-or-never proposition, but as an option to develop real assets.
A real option refers to choices on whether and how to proceed with a business investment. Real options help you to take advantage of the uncertainty of the future: by investing in a real option now, you create uncertain, long-term opportunities that you can, but don't have to, harvest later. This gives you the ability to decide later on what to do, and alter initial plans in the face of favorable or unfavorable developments. Uncertainty makes real options flexibility valuable!
Real options largely depend on the market situation, on the interactions between all the stakeholders, but most of all it depends on the management capabilities of the team and their abilities to create these options. Successful CEOs do not wait for opportunities to emerge. And you should not either, because opportunities can also be created! This is the essence of real options, which you can apply everywhere; both in your personal life and in business.
For example, when you invest in a higher education, you invest in growth options for your career. Doing a Bachelor's degree creates the option to do a Master's, which in turn improves your future chances on the job market. When dreaming of buying a house, you are holding the option to defer. This way, you can save money, get married, and explore various locations before making this financial commitment. Finally decide to buy a house, you might invest more to buy a large house with extra rooms. This gives you an option to expand your family and accommodate more children in the future. And when you have too much space, you can exercise the option to contract.
Sometimes, you even need to exercise an option to abandon, for example, when you don't want to hold on to your expensive car anymore and decide to sell it. Besides in life, you also find numerous real options in business settings. Imagine you're a car manufacturer. The option to defer gives you the flexibility to delay investment decisions until circumstances are favorable. With growth options, you open up future opportunities, forming a link in a chain of interrelated projects. With the option to expand or contract, you're flexible to upscale or downscale projects. And with the option to abandon, you can dispose of unprofitable projects completely and recover some resale value. Sometimes, it is desirable to pause projects, which you can do with the option to temporarily shut down. This allows you to start up again, under favorable circumstances. And with staged financing, investment risks can be reduced by financing high-risk projects in stages, rather than all at once. This allows you to stop when the projects' performances don't meet their expectations. Real options allow you to adapt to uncertainty.
War games
Options give you the ability to influence your future. For example, you might be thinking of expanding your production capacity by expanding your production facilities to another city. When this option is unaffected by competitors, it is a proprietary option. While options can be exclusive, more often you have to share them with competitors. To predict how others might affect your shared options, we use game theory, which is the study of competitive interaction. Rivals are the other players in a game. A game in which all players interact with each other according to rules.
When you play the game well, you can anticipate other players' moves and design your optimal strategy. Game theory is not new at all, but we take it to the next level in valuation, by combining games with real options into option games. Option games might seem contradicting: while options provide flexibility, games are based on commitment. But, both have their own significant value. The value of flexibility comes from postponing irreversible investment decisions under uncertainty to prevent bad investments. The value of commitment comes from pre-committing to irreversible investment decisions to gain strategic advantage. By moving first and committing to an investment, you take an irreversible action, which influences the options of the others. This creates a tug of war between staying flexible by waiting versus committing by investing early. To quantify value components, we use the expanded strategic present value framework, which brings together the NPV with option games. In this option games framework, players can compete and outsmart others to appropriate shared growth options. Or, players can cooperate and work together to increase shared growth option value.
Regardless of the influence of rivals on the value of growth options, they will influence the price you pay for the option. Our framework can help you assess not only what the value of an option is to you, but especially what its value is to others. This way, you can determine the optimal price you should pay when competing for an option. For instance, when you bid against rivals for a high tech venture.
In conclusion, if we want to be confident in our decision-making process when it comes to investing in various companies or projects, we need to expand our awareness of the aspects that affect the quality of the investment. Investment in a specific project will never be measured by the past of that project, but will mainly be influenced by an element of uncertainty that stems from the decision makers' strategy and abilities of project managers to both exhaust the options and create winning options for the project.