Hi Friends! Hope you like your journey with me to understand the world of valuations. Today, I want to digress a bit from my actual topic of Valuations and will tell something about qualitative aspects that help u greatly in evaluating a company prospects. In valuations, what we do is that most of the time we put efforts in collecting historical data, assumptions and other details to carry out our analysis, but we forget the underlying risks that the company might face because of those assumptions. These risks greatly affect the company’s decisions about the selection of a particular project.
Suppose there is a company which wants to decide whether to go for a project or not that gives very good return but carry a great risk. What will be your answer? Confuse. The answer to this question is actually subjective because the fate of this project lies on the designation of the person who will take that decision. Suppose the decision making lies in the hand of an investor, the best decision for him will be to go with the project as his association with the company is very limited i.e. equal to the amount of money that he invests in that company .So, he wants to maximize his return. Now, think from an CEO/CFO perspectives, he may not want to go with this project as it carries huge risks and might put his careers in trouble. What’s if the decision to select the project lies in the hand of the Board of directors, they will definitely select the projects which will not affect the health of the company in the long run. So, they will analyze its effect from all angles and will take the decision accordingly.
Do you have any idea why I gave the above example? Because I want to show that the risk taking capabilities varies from person to person.in the above situations one can easily see that for investors it is highest whereas for CEO/CFO it is lowest. Now, let’s understand the above concept with different angle. Suppose a company want to invest in a project costing Rs 10 million and will increase the value of the company by Rs 50 million in one year, but its chance of success is 60 %. Now, as a decision maker how can you evaluate the above scenario? The given table shows the different scenarios.
Now, the answer to this question is simple since the expected return is 20 million and the rate of return on project is very high i.e. 200 %, it would be better that we will go with the projects. But in real world, the scenario is totally different because there is nothing like by chance, expected or probability because there lies only two scenarios i.e. upside or downside. If it will be upside it is ok but what will happen if it is downside? Again, it depends on many factors. Suppose the total value of the firm is 8 million before the project and you used debt to finance this project. Now, what will be your answer?
No, because if it fails, your company will be in red. What if the size of your company is 1000 million, have cash reserves of 100 million and yearly cash flow of 50 million. Simply, yes. But in reality it is not like that because many companies give importance to current income or quarterly income than any future gain. So, in case of loss it will affect their income. Similarly some CEO /CFO do not go with such projects because it might affect their reputation in case of failure as risk is high. Hence, in real world decisions depend on many factors apart from delusory numbers.
Hope you like the analysis given by me. Be ready to explore the world FCFF i.e. the world of assumptions and complex calculations in my next post.