Timing investments

I was just reading this article about timing strategic moves and i think this is the key question on every CEO's lips nowadays. As the stock markets start to recover and investors slowly regain confidence, many companies predict a growth in earnings for the following year and start venturing into long term planning and strategic investments again. These strategic investments might be big investment projects or acquisitions of rivals or of complementary businesses. Indeed, there is a lot of value in M&A deals at the moment, as companies that have overcome the financial crisis and have a stable cash position can look into acquiring businesses at a discount of over 30% compared to 2007. Similarly, according to McKinsey Quarterly, some investment projects might be considerably cheaper now than they were before, although I am not sure we can say this is the case for most industries (I am inclined to believe it is more an effect in a specific sector/company than a generalized trend). In any case, investing now is a good move to secure a better competitive position, as it can give the company a headstart compared to its rivals that are cutting growth plans and focusing on the short term. Innovation will be key to get out of the slump, and developing new R&D projects is costly and time consuming - therefore there is a clear benefit for the companies that invest now and will be able to ripe the benefits of innovation much earlier than their rivals. However, we are talking about sizable investments which, if undertaken, can expose the company to a significant risk and maybe even weaken it completely. Therefore timing of these moves becomes key: executives should wait long enough to have some visibility on where the market is going, but not too long, because otherwise they will lose the inherent value in buying these projects now. If they wait too long, everybody will see the interest of these deals and will be willing to invest, the prices will go up and thus will eat up the perceived value. So how can one determine the right timing for these investments?

McKinsey Quarterly proposes scenario analysis, which, I believe can indeed be a good tool. In their case, a certain strategy was clearly superior to the others in all scenarios considered (i.e. invest now rather than wait, because the benefits of waiting are too low compared to the possible losses in the value of the projects). However, what happens if there is no such clear cut strategy emerging? Scenario analysis can give us an idea of where the value of the investment evolves depending on the direction of all the uncertain variables, but it is not always a decisional tool, as it does not offer a combined value for that opportunity on which to decide. It's not like the NPV, where you can clearly state that investing in this project is worth that much, and if it's bigger than this number, we should always go for it. With scenario analysis, you know that if scenario X happens, then your project is worth this much... in order to get a global value of the investment you need to assign probabilities to each scenario which, in my opinion, is impossible to do in the current economic context where any attempt at previsions is mere guess.

What companies need is a tool that allows them to integrate uncertainty, avoid making previsions and still help them decide whether to invest or not, and, most importantly, when is the right time to invest. For corporate internal projects, this is exactly what the Real Options method does. Based on the financial options pricing framework, namely binomial pricing , the Real Options approach considers that management has the option (the right, but not the obligation) to purchase a certain investment project by investing the required amount. This model allows companies to express the full range of the uncertainty in a binomial present value tree, avoiding the need to make predictions and commit to numbers which are impossible to get right. Real Options valuation considers that the project is actually an American call option, and so using financial options pricing allows management to identify the best timing for its exercise (i.e for making the investment). It also discounts into one single number all the possible values of the project, be they negative or positive NPVs, thus taking things one step further than scenario analysis, because it becomes a decision tool. The decision criterion is: if adjusted NPV with RO value > 0 we should invest in the project. Thus, this framework is a bit more standardized and rigorous than scenario analysis for timing investment projects and their phases. However, I have been thinking if this could also be applied to value companies for M&A?... I am not sure yet..i'm afraid I will leave this open for discussion for now.