Valuating innovative business models: quantifying the unquantifiable

ValuatingValuation is a decision-making process aimed at making smart bets on the “least bad” way to “put a number” on a business model, taking into account what is known, what is believed and the remaining ambiguities and uncertainties. Numbers are a necessary evil.

NPVThe net present value (NPV) method is a very powerful but also very dangerous technique for valuing a business model based on its expected riskiness and potential cash flows. It can in particular be effectively used to compare multiple business models under similar cost of capital and terminal value assumptions.

FuturesSensitivity analysis and scenario planning approaches can be used to integrate known risks and potential uncertainties and to reduce the scope of managerial ignorance, provided they are based on challenging business conversations regarding “what you need to believe” rather than black box models and/or blind number-crunching.

Bibliography

The valuation decision-making process:  making smart bets

  • (Book) Blastland, M. & A. Dilnot (2007) The Tiger That Isn’t. Seeing through a world of numbers
  • (Book) Christensen, C. M., Kaufman, S. P., & Shih, W. C. (2010). Innovation killers: how financial tools destroy your capacity to do new things. Harvard Business Review Press.
  • (Books) Keen, S. (2011). Debunking Economics: The Naked Emperor Dethroned?-Revised, Expanded and Integrated Edition. Zed Books.
  • (Book) Kindleberger, Charles Poor, and Robert O’Keefe. Manias, panics, and crashes. Palgrave Macmillan, 2001.
  • (Books) Knight, F. H. (2012). Risk, uncertainty and profit. Courier Corporation.
  • (Book) Mackay, C. (2002). Extraordinary popular delusions and the madness of crowds. Barnes & Noble.
  • (Video) David Rose, How to pitch to a VC (TED talk)
  • (Article) Berkovitch, E., & Israel, R. (2004). Why the NPV criterion does not maximize NPV. The Review of Financial Studies, 17(1), 239-255.
  • (Article) Brun, E., Saetre, A.S., & Gjelsvik, M. (2009). Classification of ambiguity in new product development projects. European Journal of Innovation Management, 12(1), 62-85.
  • (Article) Cassar, G. (2010). Are individuals entering self‐employment overly optimistic? An empirical test of plans and projections on nascent entrepreneur expectations. Strategic Management Journal, 31(8), 822-840.
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  • (Article) Cohen, L., Diether, K., & Malloy, C. (2013). Misvaluing innovation. The Review of Financial Studies, 26(3), 635-666.
  • (Article) Ghosal, Vivek, and Prakash Loungani. “The differential impact of uncertainty on investment in small and large businesses.” Review of Economics and Statistics 82.2 (2000): 338-343.
  • (Article) O’Connor, G.C., & Rice, M.P. (2013). A comprehensive model of uncertainty associated with radical innovation. Journal of Product Innovation Management, 30(S1), 2-18.
  • (Article) Ryan, Patricia A., and Glenn P. Ryan. “Capital budgeting practices of the Fortune 1000: how have things changed?.” Journal of business and Management 8.4 (2002): 355.
  • (Article) Segal, Gill, Ivan Shaliastovich, and Amir Yaron. “Good and bad uncertainty: Macroeconomic and financial market implications.” Journal of Financial Economics 117.2 (2015): 369-397.
  • (Article) von Gelderen, M., Frese, M., & Thurik, R. (2000). Strategies, uncertainty and performance of small business startups. Small Business Economics, 15(3), 165-181.

Carefully using net present value (NPV) to value business models

  • (Book) Copeland, Thomas E., Tim Koller, and Jack Murrin. “Valuation: measuring and managing the value of companies.” (1991).
  • (Video) Startup Valuation made simple by Serious Funding: The VC Method
  • (Article) Adner, R., & Levinthal, D.A. (2004). What is not a real option: Considering boundaries for the application of real options to business strategy. Academy of Management Review, 29(1), 74-85.
  • (Article) Chintakananda, A., & McIntyre, D. (2016, January). Strategy, innovation and options: An integrative approach and future directions. Academy of Management Proceedings 2016(1), 12280.
  • (Article) Hanafizadeh, P., & Latif, V. (2011). Robust net present value. Mathematical and Computer Modelling, 54(1), 233-242.
  • (Article) Jacob, W.F., & Kwak, Y.H. (2003). In search of innovative techniques to evaluate pharmaceutical R&D projects. Technovation, 23(4), 291-296.
  • (Article) Keeley, Robert H., Sanjeev Punjabi, and Lassaad Turki. “Valuation of early-stage ventures: option valuation models vs. traditional approaches.” The Journal of Entrepreneurial Finance 5.2 (1996): 115.
  • (Article) Robichek, Alexander A., and Stewart C. Myers. “Conceptual problems in the use of risk‐adjusted discount rates.” The Journal of Finance 21.4 (1966): 727-730.
  • (Article) Romer, P (2015). Mathiness in the Theory of Economic Growth. American Economic Review, 105(5), 89-93.
  • (Article) Ross, S.A. (1995). Uses, abuses, and alternatives to the net-present-value rule. Financial Management, 24(3), 96-102.
  • (Article) Žižlavský, Ondřej.(2014) “Net present value approach: method for economic assessment of innovation projects.” Procedia-Social and Behavioral Sciences 156: 506-512.

Integrating known risks and potential uncertainties:

  • (Book) Gilovich, T., D. Griffin and D. Kahneman, Heuristics and Biases: The Psychology of Intuitive Judgment, , Cambridge University Press, 2002
  • (Book) Razgaitis, R. (2003) Dealmaking using real options and Monte-Carlo Analysis. John Wiley, Hoboken NJ
  • (Book) Silver, N. (2012) The Signal and the Noise: Why So Many Predictions Fail—But Some Don’t. Penguin Press
  • (Video) HBR: The Six-Minute Guide to Making Better High-Stakes Decisions, Sarah Cliffe
  • (Article) Bishop, P., Hines, A., & Collins, T. (2007). The current state of scenario development: an overview of techniques. Foresight, 9(1), 5-25.
  • (Article) Bylund, P.L., & McCaffrey, M. (2017). A theory of entrepreneurship and institutional uncertainty, Journal of Business Venturing, 32(5), 461-475.
  • (Article) Cornelius, P., Van de Putte, A., & Romani, M. (2005). Three decades of scenario planning in shell. California Management Review, 48(1), 92-109.
  • (Article) Courtney, Hugh. “Decision-driven scenarios for assessing four levels of uncertainty.” Strategy & Leadership 31.1 (2003): 14-22.
  • (Article) Das, T. K., & Teng, B. S. (1999). Cognitive biases and strategic decision processes: An integrative perspective. Journal of Management Studies, 36(6), 757-778
  • (Article) Denning, S. (2006). Effective storytelling: strategic business narrative techniques. Strategy & Leadership, 34(1), 42-48.
  • (Article) Dow, J., & da Costa Werlang, S. R. (1992). Uncertainty aversion, risk aversion, and the optimal choice of portfolio. Econometrica: Journal of the Econometric Society, 197-204.
  • (Article) Goodwin, P., & Wright, G. (2010). The limits of forecasting methods in anticipating rare events. Technological forecasting and social change, 77(3), 355-368.
  • (Article) Kleinknecht, A., & Van Der Panne, G. (2012). Predicting new product sales: The post-launch performance of 215 innovators. International Journal of Innovation Management, 16(02), 1250011.
  • (Article) Hanafizadeh, Payam, Abolfazl Kazazi, and Azam Jalili Bolhasani. “Portfolio design for investment companies through scenario planning.” Management Decision 49.4 (2011): 513-532.
  • (Article) Kenney, H.S., & Pelley, B. (2014). Stories that drive the future: how narratives can improve scenario planning. Strategy & Leadership, 42(5), 28-33.
  • (Article) Jovanović, Petar. “Application of sensitivity analysis in investment project evaluation under uncertainty and risk.” International Journal of Project Management 17.4 (1999): 217-222.
  • (Article) Magni, Carlo Alberto, Stefano Malagoli, and Giovanni Mastroleo. « An alternative approach to firms’ evaluation: expert systems and fuzzy logic” International Journal of Information Technology & Decision Making 5.01 (2006): 195-225.
  • (Article) Mendonça, S., e Cunha, M. P., Ruff, F., & Kaivo-oja, J. (2009). Venturing into the wilderness: Preparing for wild cards in the civil aircraft and asset-management industries. Long Range Planning, 42(1), 23-41.
  • (Article) Popper, R. (2008). How are foresight methods selected?. Foresight, 10(6), 62-89.
  • (Article) Ruff, Frank. “Corporate foresight: integrating the future business environment into innovation and strategy.” International Journal of Technology Management 34.3-4 (2006): 278-295.
  • (Article) Van Groenendaal, Willem JH. “Estimating NPV variability for deterministic models.” European Journal of Operational Research 107.1 (1998): 202-213.
  • (Article) Xu, Chonggang, and George Zdzislaw Gertner. “Uncertainty and sensitivity analysis for models with correlated parameters.” Reliability Engineering & System Safety 93.10 (2008): 1563-1573.

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