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The basis for the determination of the cash flow that best represents the future expected performance of the business lies in the analysis of the risk profile of the business itself. This section aims at classifying some typical situations of uncertainty, and at representing the cash flows that best describe them. Exhibit 1.7 provides us with a general initial reference framework, which by the way proves useful in multiple valuation settings as well by enabling the expert to carry out a more refined comparability assessment.

Exhibit 1.7 Risk profiles and cash flows modeling

Exhibit 1.7 shows how valuations of businesses whose financial results are driven mainly by market factors or macroeconomic parameters are based generally on a single cash flow profile, referring to the scenario that management deems the most likely one (“management scenario”).

These valuations yield accurate results only when the distribution of expected results is symmetric. This condition is satisfied, for example, when the relevant risk factors depict a continuous distribution. Furthermore, it should be noted that such cash flow representation type requires historical data be both available and reliable. When there are multiple risk factors, the traditional representation centered on the management scenario may lead to undesired informational gaps.

Simulation techniques, like for instance the Monte Carlo, may in these cases improve the informational quality through the use of numerous combinations of the risk factors, yielding different expected results and different related results and valuations.

A second case is represented by the businesses subjected to idiosyncratic risks, which by their own nature are characterized by discrete (and at an extreme binary) outcomes distribution (e.g., businesses whose activity is based on the renewal of a concession). In these situations, the informational quality increases by projecting a cash flow pattern in each of the major scenarios that could take place. In practice, a final valuation can be obtained by weighting the valuations obtained in the different scenarios. As said, it is worth stressing the fact that this proceeding is sensible in those situations when risks have discrete distributions. Otherwise, the applicable case turns back to scenario A, which envisages the representation of the cash flow profile of only the most likely scenario.

For some businesses (case C of Exhibit 1.7), which are typically articulated along distinct sequential phases, risks depict a sequential structure in that value creation process is subordinated to the successful crossing of some key critical steps in the project life. This is the case, for instance, of some pharmaceutical businesses, or of the projects subjected to articulated authorization itinera (e.g., wind farms). In such situations, cash flow profiles linked to the business can be analyzed through the techniques of the event trees and of the decision trees. These techniques to deal with uncertainty have the advantage to highlight the key critical aspects in the formation of the value of a project along its life. Typically, during the initial phases idiosyncratic risks are the prevailing ones, and they can determine the survival or abandonment of an initiative. Once the uncertainty surrounding the first phases of the life cycle of an initiative has been solved, systemic (market) risk factors tend to emerge.

Such analyses on the risk profiles have important consequences on the choices regarding the determination of which is the most appropriate discount rate to be applied. Indeed, if the dominant risk is an idiosyncratic one, the risk-free rate can be used assuming a Capital Asset Pricing Model framework (Chapter 8). In the opposite case, some more complex techniques deriving from the valuation models of financial option should be used.