Business leaders and their teams need to understand this – and those who build digital-twin business models for them should appreciate the big “answer” that a whole-business model can provide.
I was lucky enough to take my MBA just as the Finance field was codifying an approach to valuing a business based on the “Capital-Asset Pricing Model” CAPM. (Don’t worry about the scary technical explanations you will find if you search for this!“
The present value of discounted future cash flows. Essentially, CAPM implies that – when deciding what a business is worth – investors estimate the future cash-flows they expect it to generate, then ‘discount‘ those values back to a today-value. The sum of those ‘present values’ = the value of the business. The more risky the business, the higher the discount rate they apply.
Why? Imagine you had $100 to invest in a friend’s business, and she said “I expect to repay you $20/year“. That’s better than you would get at the bank, but then it’s also more risky. And we all know that you only get higher investment returns if you are willing to take more risk – investing in equities rather than Govt bonds, for example.
We also know that “money I get earlier is worth more than money I get later” (Would you prefer I give you $100 now, or next year, or in 5 years’ time?) But by how much is money received later worth less than money received earlier?
If your friend had built a similar successful business before, you might say “Well, that $20/year is pretty likely, so I will discount that amount by 10% each year” So that’s $18 for her year-1 forecast; $16.20 for her year-2 forecast and so on. Add up all those numbers for as many years as you are prepared to consider and that’s how much you think your $100 investment would be worth – its “net present value” or NPV. In principle, if that number is more than $100, you should go ahead – if not, don’t.
If your friend had much less experience, you’d likely say, “Well, I’m not so confident in those forecasts, so I will discount them much more – by 30% each year” So you value the year-1 forecast at 20 * 0.7 = $14; the year-2 forecast at 20 * 0.7 * 0.7 = $9.80 etc. The sum of those “discounted future values” is clearly much less, so you would be willing to invest less in backing her.
Now of course, few real investors actually go through this process of quantifying the risk, figuring out the discount rate and working out the NPV of their investment opportunities. But the early research behind the CAPM suggested that their investing behaviour looks like what it would be if they did do it.
But what future cash flows should we evaluate? For a full answer to this question, I strongly recommend the book Valuation: Measuring and Managing the Value of Companies by Tim Koller, Marc Goedhart and David Wessels – the McKinsey seminal reference on the issue.
Very summarised again, investors in a business only get their hands on the cash flow it generates after it has paid interest and taxes (of course!), but also after deducting any cash it needs to invest in its own future growth – capital investment and increased working capital. And “profit” is not the same as cash flow from operations – we need to add back depreciation, for example.
The number you get after making these corrections is “free cash flow” – the money available to investors, after necessary spending for future growth. As I say, there’s much more on this in that Valuation book! But a warning – do not follow that book’s guidance on how to forecast those cash flows. The principles behind digital-twin business models are considerably more robust.
Valuing projects, initiatives and alternative strategies. The same NPV approach is used to evaluate projects. Early-period cash flows may be negative, as you invest the cash that you hope will build future revenues and cash flow. Then positive cash flows will hopefully pay that investment back – and more! But the value of those later, positive cash flows will be discounted, so before being discounted will need to add up to a lot more than that initial investment.
Same for some initiative you want to evaluate, like launching a new product or making an acquisition. What incremental cash flows should the initiative generate, how uncertain are those forecasts, and what is their NPV?
And we can assess alternative strategies in a similar way. We might be going for a new market opportunity, but be unsure whether to go low-price to capture customers and sales fast, but at lower profit margins, or to go higher-price to protect profitability but with lower growth. Compare the NPVs of the two choices.
Adding valuation to digital-twin business models. Provided that we “follow the rules” in our models – both for projecting future cash flows and for evaluating their present value – adding this calculation to the back-end of a business model is pretty straightforward.
This approach to valuation is explained and demonstrated in class 1 of our course, Strategy Dynamics for Leaders, on how to use models that your staff or consultants build for you.