Building flexibility into business planning

ONE of the take away lessons from the CFA curriculum is that the conventional method of valuing an investment is to determine the present value of expected future cashflows.  One way of doing this would be to use the constant growth dividend discount model, which estimates the value of a stock by assuming that dividends grow at a constant rate … forever.  If the present value of expected cash inflows exceeds the cost of the investment, then we should invest.

I hope this model of investment valuation concerns you. It certainly concerns me. It basically tells us that we should make an investment decision based on the most likely expected future.

If we are happy to agree that (1) it is not possible to predict the future and (2) past performance does not guarantee future performance, then this colour by numbers method of investment valuation leaves much to be desired.

The businesses that will prosper in the Global Financial Crisis are the ones that have flexible business plans. These are the businesses that looked into the future and saw uncertainty. These businesses understood that the state of the world in ten or even one years time is not only uncertain, but unknowable, and planned accordingly.

One company that comes to mind is Microsoft, which has a cash stockpile of some US$25 billion.  In the past, Microsoft has received considerable criticism for failing to either invest its vast cash reserves, or distribute them to shareholders.  Microsoft’s “conservative” approach now puts it in a strong position to acquire competitors who “strategically invested” their cash reserves in more prosperous times.

To quote the McKinsey Quarterly:

Corporate leaders might consider [using] robust business models incorporating some slack and flexibility instead of the models most common today, which aim to optimise value in the most likely future scenario and thus leave companies exposed when conditions change dramatically.