I will be explaining the downside to using the DCF/NPV model.
DCF/NPV Probs (Blog 3)
As mentioned in my last blog, DCF and NPV go hand in hand. The NPV compares the value of the investment amount today to its value in the future, while the DCF assists in analyzing an investment and determining its value—and how valuable it would be—in the future. For the sake of innovation, it can help determine whether or not to pursue an investment to help a company innovate.
The authors highlight two main issues when using DCF/NPV to value investment opportunities:
1. The “Do Nothing” effect
2. Errors of estimating future cash flows
Christensen explains how when mathematicians calculate DCF models, most only take into consideration two scenarios. The first being the benefit the company will get because of the innovation. The second being the cash flows if the company “does nothing”. Many assume that if a company chooses not to invest in innovation that the company will save the money and continue to have a consistent stream of cashflow. This is what he calls the “DCF Trap”. In actuality, if a company chooses not to innovate, this will most likely hurt the company because of competitors innovating and cause them to lose market share. The more accurate assumption of “doing nothing” yields a decrease in cash stream.
The second set of problems with DCF calculations relates to errors in estimation. Estimating future cash flows are extremely hard to predict. For instance, no company in the world could have ever predicted the positive or negative effects of COVID-19. While a company may be able to accurate predict cash streams for a couple years, Christensen calls predictions of 5+ years a mere “shot in the dark”. He also believes a root cause in companies underinvesting in innovations needed to sustain long-term success is partially due to the overuse of the NPV analysis. While numbers to help with decision making are important, they aren’t and shouldn’t be used as the only metric.