The Hard Thing About Innovation Valuation

July 31, 2014

When I talk to corporate decision makers about innovation, they immediately recognize that investing into uncertain and ambitious opportunities is essential for new market creation and sustaining their business in the long term.  They consider this notion common sense. The difficulty they face when trying to bring this idea to fruition, is that their common sense is firmly contradicted by financial analyses used in the capital budgeting process. Such financial analyses mainly revolve around calculating the net present value (NPV) of different opportunities, and ranking them accordingly. The challenge of using NPV in capital budgeting lies predominantly in: (a) getting the discount rate right, and (b) correctly estimating the future cash flows in both size and timing. For predictable investments, it is doable to get both the discount rate and the future cash flows right within a certain range, and NPV will provide you with enough insight to correctly prioritize investment opportunities. When you force NPV on more unpredictable investments, some adverse -albeit implicit- effects arise.  Innovation related investments are uncertain by nature. Therefore the flexibility in the exploitation of such opportunities is of great value to investors. It allows them to leverage contingencies, avoid pitfalls, or even "fail fast" when necessary. Unfortunately, regular NPV calculation does not allow for valuation of flexibility.  To complicate matters, in valuation, uncertainty is directly related to risk. This leads to higher discount rates, resulting in a lower NPV. Other than that, estimating both timing and size of cash flows is a tricky, if not an impossible task in an inherently uncertain environment. Therefore, one starts to "carefully estimate" cash flows, leading to the second driver of undervaluation of innovation investments. Both effects push innovation investments down in the capital budgeting ranking. Despite knowledge of this phenomenon, many organizations are stuck with NPV as their one and only yard stick to evaluate investment opportunities, partly because  all investments should be judged both formally and equally. Another explanation is that many executives are simply unaware of other available techniques. Unfortunately, this "one size fits all" approach is undermining their ambition of new market creation and sustaining their business models. Defining what innovation means within the organization, and treating innovation investments without the above mentioned biases in is a first step towards a better valuation of innovation.

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by Mathias Cobben @Mathcob

image credit: CC - Aaron Patterson