Prediction is very difficult, especially about the future.
Niels Bohr. Danish physicist (1885 – 1962)
Strategy @ Risks models provide the possibility to study risk and uncertainties related to operational activities; cost, prices, suppliers, markets, sales channels etc. financial issues like; interest rates risk, exchange rates risks, translation risk , taxes etc., strategic issues like investments in new or existing activities, valuation and M&As’ etc and for a wide range of budgeting purposes.
All economic activities have an inherent volatility that is an integrated part of its operations. This means that whatever you do some uncertainty will always remain.
The aim is to estimate the economic impact that such critical uncertainty may have on corporate earnings at risk. This will add a third dimension – probability – to all forecasts, give new insight: the ability to deal with uncertainties in an informed way and thus benefits above ordinary spread-sheet exercises.
The results from these analyzes can be presented in form of B/S and P&L looking at the coming one to five (short term) or five to fifteen years (long term); showing the impacts to e.g. equity value, company value, operating income etc. With the purpose of:
- Improve predictability in operating earnings and its’ expected volatility
- Improve budgeting processes, predicting budget deviations and its’ probabilities
- Evaluate alternative strategic investment options at risk
- Identify and benchmark investment portfolios and their uncertainty
- Identify and benchmark individual business units’ risk profiles
- Evaluate equity values and enterprise values and their uncertainty in M&A processes, etc.
Methods
To be able to add uncertainty to financial models, we also have to add more complexity. This complexity is inevitable, but in our case, it is desirable and it will be well managed inside our models.
People say they want models that are simple, but what they really want is models with the necessary features – that are easy to use. If something is complex but well designed, it will be easy to use – and this holds for our models.
Most companies have some sort of model describing the company’s operations. They are mostly used for budgeting, but in some cases also for forecasting cash flow and other important performance measures. Almost all are deterministic models based on expected or average values of input data; sales, cost, interest and currency rates etc.
We know however that forecasts based on average values are on average wrong. In addition will deterministic models miss the important uncertainty dimension that gives both the different risks facing the company and the opportunities they bring forth.
S@R has set out to create models that can give answers to both deterministic and stochastic questions, by linking dedicated Ebitda models to holistic balance simulation taking into account all important factors describing the company. The basis is a real balance simulation model – not a simple cash flow forecast model.
Both the deterministic and stochastic balance simulation can be set about in two different alternatives:
- by a using a EBITDA model to describe the companies operations or
- by using coefficients of fabrications (e.g. kg flour pr 1000 bread etc.) as direct input to the balance model – the ‘short cut’ method.
The first approach implies setting up a dedicated Ebitda subroutine to the balance model. This will give detailed answers to a broad range of questions about markets, capacity driven investments, operational performance and uncertainty, but entails a higher degree of effort from both the company and S@R. This is a tool for long term planning and strategy development.
The second (‘the short cut’) uses coefficients of fabrications and their variations, and is a low effort (cost) alternative, usually using the internal accounting as basis. This will in many cases give a ‘good enough’ description of the company – its risks and opportunities. It can be based on existing investment and market plans. The data needed for the company’s economic environment (taxes, interest rates etc) will be the same in both alternatives:
The ‘short cut’ approach is especially suited for quick appraisals of M&A cases where time and data is limited and where one wishes to limit efforts in an initial stage. Later the data and assumptions can be augmented to much more sophisticated analysis within the same ‘short cut’ framework. In this way analysis can be successively built in the direction the previous studies suggested.
This also makes it a good tool for short-term (3-5 years) analysis and even for budget assessment. Since it will use a limited number of variables – usually less than twenty – describing the operations, it is easy to maintain and operate. The variables describing financial strategy and the economic environment come in addition, but will be easy to obtain.
Used in budgeting it will give the opportunity to evaluate budget targets, their probable deviation from expected result and the probable upside or down side given the budget target (Upside/downside ratio).
Done this way analysis can be run for subsidiaries across countries translating the P&L and Balance to any currency for benchmarking, investment appraisals, risk and opportunity assessments etc. The final uncertainty distributions can then be “aggregated’ to show global risk for the mother company.
An interesting feature is the models ability to start simulations with an empty opening balance. This can be used to assess divisions that do not have an independent balance since the model will call for equity/debt etc. based on a target ratio, according to the simulated production and sales and the necessary investments. Questions about further investment in divisions or product lines can be studied this way.
Since all runs (500 to 1000) in the simulation produces a complete P&L and Balance the uncertainty curve (distribution) for any financial metric like ‘Yearly result’, ‘free cash flow’, economic profit’, ‘equity value’, ‘IRR’ or’ translation gain/loss’ etc. can be produced.
In some cases we have used both approaches for the same client, using the last approach for smaller daughter companies with production structures differing from the main companies.
The second approach can also be considered as an introduction and stepping stone to a more holistic Ebitda model.
Time and effort
The work load for the client is usually limited to a small team of people ( 1 to 3 persons) acting as project leaders and principal contacts, assuring that all necessary information, describing value and risks for the clients’ operations can be collected as basis for modeling and calculations. However the type of data will have to be agreed upon depending on the scope of analysis.
Very often will key people from the controller group be adequate for this work and if they don’t have the direct knowledge they usually know who to ask. The work for this team, depending on the scope and choice of method (see above) can vary in effective time from a few days to a couple of weeks, but this can be stretched from three to four weeks to the same number of months.
For S&R the time frame will depend on the availability of key personnel from the client and the availability of data. For the second alternative it can take from one to three weeks of normal work to three to six months for the first alternative for more complex models. The total time will also depend on the number of analysis that needs to be run and the type of reports that has to be delivered.
Selecting strategy
Models like this are excellent for selection and assessment of strategies. Since we can find the probability distribution for equity value, changes in this brought by different strategies will form a basis for selection or adjustment of current strategy. Models including real option strategies are a natural extension of these simulation models:
If there is a strategy with a curve to the right and under all other feasible strategies this will be the stochastic dominant one. If the curves crosses further calculations needs to be done before a stochastic dominant or preferable strategy can be found:
Types of problems we aim to address:
The effects of uncertainties on the P&L and Balance and the effects of the Boards strategies (market, hedging etc.) on future P&L and Balance sheets evaluating:
- Market position and potential for growth
- Effects of tax and capital cost
- Strategies
- Business units, country units or product lines – capital allocation – compare risk, opportunity and expected profitability
- Valuations, capital cost and debt requirements, individually and effect on company
- The future cash-flow volatility of company and the individual BU’s
- Investments, M&A actions, their individual value, necessary commitments and impact on company
- Etc.
The aim regardless of approach is to quantify not only the company’s single and aggregated risks, but also the potential, thus making the company capable to perform detailed planning and of executing earlier and more apt actions against uncertain factors.
Used in budgeting, this will improve budget stability through higher insight in cost side risks and income-side potentials. This is achieved by an active budget-forecast process; the control-adjustment cycle will teach the company to better target realistic budgets – with better stability and increased company value as a result.
This is most clearly seen when effort is put into correctly evaluating strategies-projects and investments effects on the enterprise. The best way to do this is by comparing and Choosing strategies by analyzing the individual strategies risks and potential – and select the alternative that is dominant (stochastic) given the company’s chosen risk-profile.
A severe depression like that of 1920-1921 is outside the range of probability. –The Harvard Economic Society, 16 November 1929
