Copyright  ©  2014  by  Incite!  Decision  Technologies,  LLC  

The  Value  of  Knowing  What  You  Don't  Know  Or,  for  the  real  punk  rockers  out  there,  the  value  of  including  uncertainty  in  business  case  analysis Robert  D.  Brown  III  Incite!  Decision  Technologies,  LLC  

The  Problem  –  “How  Do  We  Communicate  the  Value?”  Few  of  us  really  like  uncertainty.  It  fills  us  with  dread.  It  frustrates  our  planning  efforts.  It  makes  analyzing  its  effects  complex.  After  all,  where  in  a  spreadsheet  do  you  put  uncertain  values  for  revenue  or  costs?  Admittedly,  accounting  for  uncertainty  can  be  difficult,  but  doing  so  can  add  a  lot  of  value  to  your  business  decisions.  Let  me  explain…    A  colleague  recently  took  on  the  opportunity  to  broker  the  sale  of  a  resort  hotel.  The  hotel  was  recently  refurbished  and  now  operates  profitably  at  an  approximate  69%  occupancy  rate  for  an  average  nightly  room  rate  of  $219.  It  also  gathers  a  healthy  food  &  beverage  income  as  well  as  rental  income  from  stores  that  operate  on  the  promenade  level.  The  sellers  offered  the  hotel  at  a  premium  price,  arguing  that  the  refurbishments  and  marketing/operating  strategy  that  they  will  pursue  (part  of  the  deal  is  that  they  will  continue  to  operate  the  property)  will  continue  to  grow  the  occupancy  rate  to  a  target  72%  and  the  room  rate  to  $275/night.  Unfortunately,  the  hotel  has  been  slow  to  close  a  deal,  so  now  the  sellers  want  to  add  a  sweetener  to  their  offer:  for  the  next  five  years,  the  hotel  EBITDA  (earnings  before  interest,  taxes,  depreciation,  and  amortization)  will  return  4%  on  the  sale  price  of  the  hotel;  if  it  doesn’t,  the  sellers  will  make  up  the  shortfall.  “Rob,  how  do  we  communicate  the  value  of  the  guarantee?”

The  Solution  –  Account  for  Uncertainty  Notionally,  the  answer  to  my  colleague’s  question  would  be  that  the  value  of  the  guarantee  is  the  sum  of  the  present  value  of  the  shortfalls  from  the  guaranteed  annual  return.  In  fact,  the  current  forecast  pro  forma  of  the  hotel  includes  the  EBITDA  with  the  anticipated  rates  of  growth  in  the  occupancy  and  room  rates.  If  the  hotel  sold  on  January  1,  2014,  the  EBITDA  compared  to  the  guaranteed  return  would  look  like  the  following:    

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At  first,  the  EBITDA  falls  below  the  Guaranteed  Annual  Return,  but  it  catches  up  with  it  after  the  second  year...or  does  it?  (Figures  in  millions)

The  value  of  the  shortfall  (where  the  red  curve  falls  below  the  blue)  in  this  best  guess  scenario  is  $1.5  million.  But  there’s  a  problem  with  this  analysis.  Can  you  guess  what  it  is? You’re  right.  The  analysis  does  not  include  the  likelihood  that  the  hotel  seller/operators  will  achieve  the  desired,  targeted  rates  of  growth.  Maybe  the  market  won’t  absorb  the  additional  $56/night.  Or  maybe  another  recession  will  wreck  the  resort  industry  again.  Or  maybe  the  occupancy  rates  are  nearing  their  natural  absorption  for  the  value  the  hotel  offers  so  that  the  additional  3%  lift  on  the  current  rate  is  a  long  shot.  Some,  all,  or  more  of  these  caveats  could  come  to  bear  on  the  owners  and  operators  over  the  next  five  years. By  carefully  calibrating  the  range  of  uncertainties  for  the  key  business  model  parameters  and  by  using  Monte  Carlo  simulation,  we  discovered  that  the  likely  range  of  outcome  around  the  average  EBITDA  (indicated  by  the  error  bars  around  the  Annual  EBITDA)  probably  looks  more  like  this:    

The  potential  range  in  the  EBITDA  may  still  overlap  the  Guarantee  in  later  years.  The  

Guarantee  continues  to  provide  value.  (Figures  in  millions)

What is Monte Carlo simulation? It’s a way to represent uncertainty about what can happen or what we know is the case by randomly selecting a large number of values according to a defined pattern and combining those values mathematically with other values that also may be randomly drawn.

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The  result  is  that  the  average  of  the  potential  annual  shortfall  is  much  greater  than  originally  anticipated:

The  average  shortfall  exists  because  there  are  some  futures  in  which  it's  possible  that  the  EBITDA  fails  to  overcome  the  

return  guarantee.  This  information  is  lost  by  using  single  point  analysis.  (Figures  in  millions)  

When  we  perform  our  original  value  calculation  on  the  large  number  of  possible  futures  with  their  probability  weighted  prevalence  in  our  simulation,  we  now  find  that  the  value  of  the  guarantee  is  most  likely  between  $1.1  million  and  $7.2  million  (the  80th  percentile  interval),  with  an  expected  value  of  $3.4  million!  

The  Conclusion  –  There  is  Value  in  Uncertainty  What  did  we  learn  from  this  analysis?  

o The  value  of  the  guarantee  is  actually  2.2  times  more  valuable  than  the  original  analysis  implied  by  not  including  uncertainty.  

o The  value  of  including  the  uncertainty  in  the  analysis  is  the  difference  between  the  value  with  uncertainty  less  the  value  without  uncertainty.  In  this  case,  the  value  of  including  uncertainty  in  the  business  case  analysis  is  $1.9  million  (i.e.,  $3.4  million  -­‐  $1.5  million).  

o The  sellers  possess  both  the  reasonable  and  ethical  capability  to  communicate  a  much  better  value  of  their  guarantee  to  a  potential  buyer.  

o The  sellers  recognize  that  they  likely  face  more  exposure  with  their  guarantee  than  they  originally  assumed,  and  they  know  the  quantity  and  likelihood  of  different  levels  of  exposure.  Now  they  can  adjust  the  terms  of  their  guarantee  or  plan  how  they  can  hedge  against  the  exposure.  

None  of  us  possess  perfect  knowledge  about  the  future,  but  masking  that  shortcoming  with  single  point  analyses  introduces  another  source  of  risk  by  inattention.  By  explicitly  addressing  and  categorizing  what  we  do  not  know,  we  can  actually  discover  more  sources  of  value  and  risk  that  we  previously  overlooked.  The  result?  We  pick  up  found  money,  reduce  the  anxiety  associated  with  lingering  doubts  about  what  may  come,  and  make  better  plans  to  hedge  the  risks  that  threaten  our  wealth.  

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Mmmmm.  Smell  that?  That’s  the  warm,  inviting  aroma  of  coffee.  Let  me  buy  you  a  cup,  or  two,  and  let’s  discuss  how  you  can    o Improve  the  value  of  your  decision  making  o Reduce  the  risk  of  important  planning  activities  

by  including  uncertainty  in  your  business  case  analysis.    

Click  here  to  contact  me  to  find  out  more.    

   

(If  the  click  link  above  doesn’t  work,  copy/paste  http://www.incitedecisiontech.com/contact.shtml

into your browser)    

       

 Robert  D.  Brown  III   is  the  President  of  Incite!  Decision  Technologies,  LLC.  Robert  has  devoted  his  twenty-­‐year  career   to   providing   solutions   to   his   clients’   complex   problems   by   employing   creative   thinking   and   advanced  quantitative   business,   engineering,   and   systems   analysis.   His   experience   spans   diverse   industrial   and  commercial   fields   including   petroleum   and   chemicals,   energy,   utilities,   logistics   and   transportation,  pharmaceuticals,  electronics  manufacturing,  telecommunications,  IT,  commercial  real  estate,  and  education.  He  may  be  contacted  at  rdbrown@incitedecisiontech.com  .