Improve the valuation of your strategic investments
How to get past the limitations of Net Present Value (NPV)? By relying on two advances in strategic research, namely, real option theory and game theory.
Many companies use Net Present Value (NPV) as their main tool for the valuation of investment projects. Based on an analysis of estimated costs and benefits, they deduct profitability and decide whether or not to go ahead with an investment.
Although the simplicity of this approach makes it attractive, it is nonetheless incomplete. Two essential factors in valuing a strategic project are indeed overlooked. First, it ignores the value of the frequent possibility for the company to adjust the content of a project according to initial results. Second, it leaves out an important strategic dimension, namely how the value of the investment will be influenced by competitor reactions.
Strategists have long been aware that the purely financial approach to strategic investment is incomplete. To remedy this, companies are encouraged, for example, to favor investments that help control key success factors, impose a standard on the market or develop their core competencies. Yet, until recently, there was no method to translate these strategic dimensions into financial value.
Two recent advances in strategic research help take the strategic dimension into account when projecting the financial value of an investment:
– Real option theory, which values the ability of companies to adjust their investments as events unfold.
– Game theory, which takes account of how competitive moves influence the value of strategic investments.
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