by Clayton M. Christensen, Stephen P. Kaufman, and Willy C. Shih
This is a great article in the January 2008 edition of HBR (reprint R0801F) on the critical traps in deploying classic financial tools to innovation. One of the more provocative issues discussed is the assumption that if the business does nothing the current cash flows will remain. The flaw in this logic is the concept of “the fade” – if a business does nothing to support its position, the business quality will fade ~10% per year due to stronger competitors and/or stronger customers. Clayton Christensen relates this to classic DCF analyses in the following graph. I highly recommend ordering the reprint for the full article....
The DCF Trap
Most executives compare the cash flows from innovation against the default scenario of doing nothing, assuming—incorrectly—that the present health of the company will persist indefinitely if the investment is not made. For a better assessment of the innovation’s value, the comparison should be between its projected discounted cash flow and the more likely scenario of a decline in performance in the absence of innovation investment.