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In order to set forth in an organized fashion the crucial problem of every evaluation, it is necessary to understand the reasoning that guides the process of valuation in a context in which the results of an investment, or of a business, cannot be certainly determined in advance, but can only be estimated.

In order to introduce the problem of uncertainty with the pragmatic approach more suitable to the needs of a business or financial analyst, it is useful to start from some basic concepts:

● The performance of industries is characterized by different degrees of predictability and, therefore, uncertainty. For example, trend in demand in the public utilities sector shows a significant correlation with the trend in the GDP, or the total family income. In other sectors, demand is a function of different macroeconomic variables, such as industrial investments, interest rates, etc. Generally, though, these correlations are more weak because some factors, such as lifestyle evolution or consumer behaviour, can have a great influence on the demand. Further, some other industries are extremely sensitive to economic trends (typically, the intermediate sectors, investment goods sectors for which demand is formed by other industries). Finally, some industries are less cyclical (e.g., some food sectors, and the pharmaceutical industry).

● New ventures, or firms that develop innovative strategies, face a different kind of uncertainty than traditional or consolidated industries. In fact, in traditional industries historical information helps to identify systematic correlations between the economic environment and a firm's expected results. In innovative ventures lacking significant historical comparisons, uncertainty can be associated with the idea of probability as an expectation of future events: therefore, estimates are largely subjective (uncertainty = belief).3 Such a concept of uncertainty, in general, is contrasted by academics with the notion of probability that past events repeat themselves (in such case, the concept of probability is associated with that of frequency).

● Firms, as organizations of individuals competing on the market, generate evolutionary phenomena that constitute risk factors for other firms, which in turn react by generating new changes. Therefore, we must abandon the idea, implicitly accepted by finance theorists, that uncertainty is a situation passively faced by firms. In the real world, uncertainty is managed by firms that seek to exploit favorable opportunities and limit the downside of unfavorable events. Management, indeed, by its own decisions continuously molds the risk profile characteristic of its core activity. That is, management style, interaction with the economic environment, and adopting innovative approaches rather than passive adaptation are fundamental factors in adjusting the degree of uncertainty associated with external factors, common to all the firms belonging to the same strategic business area.

In the valuation of investments, acquisitions, or businesses, different forms of uncertainty can coexist – although, generally, one form tends to prevail over the others.

On the one hand, there are valuations of companies that operate in highly stable macroeconomic contexts, in highly predictable industry, and whose future performance is characterized by high visibility. Such cases of “easy” valuations become less and less frequent in the current context of erratic economies and turbulent financial markets.

1.4.1 Organizing the Analysis

Financial analysts approach the issue of uncertainty in forecasting by adopting logical tools and models developed in the area of industrial economics and of strategy. Exhibit 1.3 shows a simplified description of a typical analysis workflow.

Exhibit 1.3 Uncertainty analysis

Business Model Analysis

Typically, analysts use the expression business model to assess the characteristics of the products or services offered by a firm, the marketing choices adopted, and the production decisions. In the business model analysis, analysts seek to understand the cost/revenues structure of the firm or of the investment project. An example can help clarify the concept.

Alpha is the European leader in automated equipment for manufacturing and packaging for the pharma industry (blisters, boxes, wrappers, case packers, and palletizers). In the pharma industry, a fundamental feature of production equipment is reliability while price is a secondary issue. Alpha has consolidated its leadership position by systematically investing a significant portion of its revenues in improving equipment for specific functions and researching innovative technical solutions. Non-core components production has been assigned to different companies. Equipment is marketed by a European and North American distribution network. Technical support, spare parts sales, and equipment updates represent a significant fraction of the overall gross margin.

This scant information defines the “business model” and lets us understand that the revenue share emerging from equipment sales, being related to the pharmaceutical industry, is only marginally affected by cycles and is complemented by further revenues, with high margins and no cyclicity (as, for instance, in the after-sales support business).

Under the cost structure planning, assembly, setup, and a significant share of the R&D costs are largely inelastic, because they require a highly specialized staff, which is a strategic resource of the company and is fundamental to the growth outlook for Alpha.

Production costs are, on the other hand, relatively flexible: as previously noted, Alpha assigns the manufacturing of noncore components of its own products to a small selected number of suppliers, mostly located in the same geographical area.

Market and Competitors Analysis

The next step consists of the analysis of the environment external to the company, in order to understand the firm's market positioning relative to competitors and therefore the prospects for growth and profit. At this stage the analysis focuses on the business lifecycle and the competitive pressure which characterize the industry, the threat of substitute products, the entry barriers and potential competitors, and the relationship between customers and suppliers.

In the Alpha case, the pharmaceutical industry is characterized by a sustained growth rate, both in Europe and in the USA (over 7 % per year in real terms). Industry analysts believe this trend is destined to last in the future.

By examining balance sheets for the most important pharmaceutical firms, one observes a strong correlation between revenue growth rate and spending on technical investments.

Just a small number of competitors are active in Alpha's market niche. Potential supply is represented by packaging equipment firms, which generally develop less reliable technologies than the standard pharma industry requirements.

Risk Profile Analysis

Typically the assessment of risk profile begins with a classical SWOT analysis of the competitive environment and the competitors.4

The case under consideration doesn't show significant risk factors: entry in the industry is limited by specific technical competence needed to produce the equipment targeted for the pharmaceutical industry and by the market reputation of Alpha. Thus, there are no reasons to induce the analyst to delineate alternative competitive scenarios (for instance, the entry of a newcomer with resulting reduction of market share or margin squeezes). Yet, this approach can be easily shared provided Alpha can keep up with a growth rate consistent with the pharma industry rate and can complete its product range by acquiring competitors working in related market niches.

Consolidating Alpha's market share could allow for an extension of the product range offered: from mere equipment sales to planning the whole production cycle as a general contractor. Moreover, Alpha could step into the business machines used in the cosmetic industry that, although not as demanding in terms of the technological specifications as the pharma industry ones, show significant similarities.

3

It's well known that the different phases of the life cycles of firms and industries are characterized by different levels of uncertainty. Scholars are of the opinion that there exists a stable and demonstrated relationship among the risk profile type of industry and life cycle of the very same industry. In the initial phases of the cycle (so-called “introduction” and “development”), the risks are particularly elevated, with the consequent possibility of huge losses of invested capital. In general, in the innovative sectors uncertainty and the difficulty of forecasting are well-known risk factors.

4

The most widely used models are the Porter five forces – Michael Porter, Competitive Strategy (New York: The Free Press, 1980) – and the strategies and competitive advantages matrices – M. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: The Free Press, 1985).