Investment decisions in an uncertain environment
To navigate an enterprise under an uncertain environment, we need tools that both specify the earning potential and weigh the existing uncertainty.
Business projections are a crucial initial step to valuing the enterprise, whether it is a new project, a major acquisition, or even a restructuring of an existing company. A general tendency is to construct business projections represented by a single value per time point, as for example monthly future sales in years ahead, and so one, giving a single two-dimensional representation.
We need to consider that the future cannot be represented by a single number or even a range of numbers. Sales, and even more critical, cash flow generation, in future periods, are insufficiently characterized in a two-dimensional representation.
Companies are usually valued through a methodology that gives us a certain range of values under certain assumptions. Uncertainty in a business environment spanning 4-8 years, the typical one in a traditional valuation, is expressive to simply be represented by a range of values. Also considering that not even the premises could be correctly represented with a simple range of values.
But the problem is even deeper and transcend the uncertainty in projections. When valuing a company, new business, acquisition, or enterprise, we need to define assumptions for variables that are totally beyond our control and often beyond our understanding, such as growth rates, risk rates, and how they evolve in a long prospective period.
We need a methodology that allows us to evaluate, by the same rule, all types of businesses, whether it is an acquisition, a new venture, or even a financial investment. We need to be able to compare all these different types of investments. This single rule will have to weigh both the relative return of every possible business, its risk, time horizon, and resource exposure; all under the same initial assumptions of economic growth and risk rates. The methodology needs to go beyond the two-dimensional description of the data variables, at least, on the most sensible ones. The requirement is not small, but perfectly possible within the calculation power that we have at our disposal today.
Current technology allows us to simulate literally millions of generated scenarios. That is, we can generate distributions for both, our assumptions and inputs, and for valuation and risk results themselves. This allows us to test countless possibilities and scenarios at a speed of a few minutes.
Our software creates multiple probabilistically distributed scenarios for the assumptions, which soon serve as input to the Valuation simulations. We thus obtain a probabilistically weighted valuation for the company, business or venture.
The ranges of values for decision making are now represented probabilistically, for example:
a) The simulated value for the company with probability greater than a certain minimum, compatible in all the projective scenarios.
b) The minimum acceptable value for the company based on a high probability level in all projective scenarios.
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