The list of “unexpected” financial crises is long. Those who were caught by surprise like to state that “nobody saw the crisis coming”. Scenario analyses can help.
The reason why the investment community is taken by surprise is that the dominant methodology they use, the discounted cash flow method (DCF), was not designed to highlight surprises, but was built around the assumption that all else is equal. However, what if the future cash flows are highly uncertain? Disruptive scenarios have been used for more than four decades to “think the unthinkable” and to make uncertainties explicit. For internal decision making of the company, DCF has been supplemented with the real option theory, to value uncertainty. But scenario analyses and real options are rarely used in analyst reports meant for external investors. Most investment analyst reports still use forecasts and DCF as the basis for their buy-sell-hold advice, whereas this choice of methodology underestimates or even totally negates specific “known” downside risks and, at the same time, also misses opportunities for future “upside” risks.
This has implications for asset owners, asset managers and investment analysts. For asset owners like pension funds, this implies that they will determine which “externalities” should be taken into account. Not only because they will want to be aware of future potential risks and opportunities, but also because they will be required to do so from their Pensions Authority In turn, this requires of asset managers that they integrate scenario-based valuation methods in their investment decision making. For investment analysts, this requires a new way of working. Scenarios and real options have been applied for decades to deal with uncertainty on a company level.
However, the application of scenarios-based valuation in analyst reports is relatively new. Investment analysts could start to articulate potential disruptive scenarios which can help both companies and investors to prepare for them. In turn, companies and investors could take up the responsibility of sharing their insights regarding possible future developments that they find important. This could help all parties involved to be better prepared for the future, at all levels. This will not prevent disruptive scenarios from occurring, but could make the investment community as a whole less surprised and more resilient against inevitable future shocks.
Read the full article by Paul de Ruijter here:
