Finance and R&D can get along
You’ve just finished briefing the executive committee on the methods for project valuation that you have worked so hard to establish in your R&D group. The team has finally acknowledged that risk needs to be managed in all its potential forms. You’ve reached consensus on the following set of risks that will be characterized as ranges, using probability distributions in your business models:
- Market share
- Willingness to pay
- Product yield
- Product cost
- Technology feasibility/R&D cost and schedule
Everyone can feel the meeting coming to a close, with nods of approval coming from all around the table. Just then, the representative from Finance clears his throat: “This looks like an enormous amount of work for very little gain. For the last fifty years, the accepted method to account for investment risk has been the Capital Asset Pricing Model (CAPM): All we need to do is calculate the net present value for each project using the appropriate risk-adjusted discount rate. All of this Monte Carlo foolishness is wasted effort.”
Is he right? I don’t think so. Finance and R&D have different perspectives on the job-to-be-done, and this creates a difference of opinion on the proper methods to employ. Like the parable about the chicken and the pig, Finance (cluck cluck) is involved but R&D (oink oink) is committed.
Both groups want to select the best projects to invest in. For Finance, the obligation (usually) stops there. In reality, this is not enough: R&D always needs to follow through with superior execution, mitigating risks as they arise. Moreover, as the team learns about the market and the technology, the project may reveal itself to be less lucrative, and no longer worthy of continued investment.
The focus on pure project selection is one reason Finance might be satisfied with CAPM. Another might be the distinguished legacy of CAPM in the last half century of financial analysis. However, there are several reasons CAPM doesn’t go far enough for R&D.
Using CAPM in R&D valuation
How do you calculate the right risk-adjusted discount rate using the Capital Asset Pricing Model? One begins with a risk free rate for acquiring capital, which is based on the current treasury rate or another well-established borrowing rate. One then adjusts this rate based on the historical variability in returns for the investment option in question (known as β).
But finding the right β is tricky in R&D. There is no track record when considering a single R&D project within a firm; you cannot look at the variability in performance for the firm as a whole. Nor is it easy to find a proxy in the market for any single, particular R&D initiative: You are unlikely to find something similar in the markets because what you are considering is probably not yet IPO-worthy, were it outside of the protective shell of your R&D group.
You are not on the outside looking in. You can do better!
Sharpe, Markowitz and Miller gave investors some useful tools for evaluating investment options when they introduced the CAPM. But these tools were designed to give insights to investors who were not privy to every strategic and tactical plan associated with a company. They are blunt tools that use a narrow beam of historical data to forecast future variability. If you are working inside an R&D organization, and have intimate knowledge of a specific initiative, with all the market assessments, product prototypes, and manufacturing know-how at your disposal, why satisfy yourself with such a narrow-band signal?
The objective of the forecast is insight, not numbers!
With a tip of the hat to Richard Hamming, we need to remind ourselves why we are forecasting cash flows in the first place: From the perspective of R&D, we aren’t trying to distill the project to a single number for rule-driven culling; rather, we want insight into the true risks and opportunities associated with a new and potentially lucrative endeavor. Applying a β-adjusted discount rate does nothing to identify or mitigate the specific unknowns associated with a project’s technical feasibility, market acceptance, or regulatory approval. In fact, it diverts the discussion away from the actual risks and mitigation options.
Making a case for business models with explicit risk assessment
What to do? We have found success in bringing Finance around to understand the imperative for a fact-based, bottom-up assessment of project risks and value. One way to do this is to demonstrate the value of the risk-based product and portfolio forecasts.
At one mid-sized pharmaceutical firm we assisted, the tradition had been for R&D leadership to show the board a curve of expected revenue vs. target revenue. We helped them establish a forecasting framework that accounted for critical development and market risks. With this framework in place, they were able to present the revenue forecast as a range (10-50-90 fractiles) against each budget alternative. Even more interesting, they began to provide an indication of the probability of hitting the target revenue in an out year (e.g. current year +5). That gave the board a better idea of whether they should invest even more in R&D now to boost the probability of hitting the out-year revenue. The board responded very positively and this is now a standard discussion in their annual board presentation.
Will the real discount rate please stand up?
Whenever finance-minded people start talking to me about CAPM-derived discount rates, I ask what the range of appropriate discount rates might be. Most talk about appropriate rates being between 5-12%. Yet there is so much risk in early stage R&D that the discount rate needed to account for that risk might be unexpectedly (or unpopularly) high. In the figure below, look at the variability in net present values when you use different discount rates on an eight-year develop-launch-retire product life cycle. As you shift the discount rate from 5% to 40%, your NPV slides from around $150M to -100M. But if you consider that the product may have an 80% chance of being abandoned half-way through R&D activities (still a pretty respectable 1-in-5 success rate), a simple expected NPV calculation (at a risk-free rate of 5%) yields a value equivalent to the risk-adjusted discount rate of 30%. Is anyone prepared to use rates of 20 or 30%, or even higher, to account for risk?
In this example, the value of a project with an 80% chance of failure corresponds to a 30% CAPM-derived discount rate.
Use carrots, not sticks
So, rather than discrediting it entirely, we like to frame CAPM as one tool that can be used to assess project value, albeit one that is often favored by Finance. Do your best to inculcate Finance in the broader tool kit that is needed for both project refinement and executive decision making in the R&D portfolio management process. Helping them see the value in a risk-based business model will win them over more effectively than if you simply argue against CAPM for R&D valuation.
Our business forecasting software, the Enrich Analytics Platform, incorporates advanced project valuation techniques into R&D Portfolio Management. For more information, contact us.
