Clayton M. Christensen, et al. may overstate their case when they call discounted cash flow (DCF) and net present value (NPV) calculations innovation killers, and I would hardly say that such “financial tools destroy your capacity to do new things,” but they do point to a common misapplication of those tools:
While the mathematics of discounting is logically impeccable, analysts commonly commit two errors that create an anti-innovation bias. The first error is to assume that the base case of not investing in the innovation — the do-nothing scenario against which cash flows from the innovation are compared — is that the present health of the company will persist indefinitely into the future if the investment is not made. As shown in the exhibit “The DCF Trap,” the mathematics considers the investment in isolation and compares the present value of the innovation’s cash stream less project costs with the cash stream in the absence of the investment, which is assumed to be unchanging. In most situations, however, competitors’ sustaining and disruptive investments over time result in price and margin pressure, technology changes, market share losses, sales volume decreases, and a declining stock price. As Eileen Rudden at Boston Consulting Group pointed out, the most likely stream of cash for the company in the do-nothing scenario is not a continuation of the status quo. It is a nonlinear decline in performance.It’s tempting but wrong to assess the value of a proposed investment by measuring whether it will make us better off than we are now. It’s wrong because, if things are deteriorating on their own, we might be worse off than we are now after we make the proposed investment but better off than we would have been without it. Philip Bobbitt calls this logic Parmenides’ Fallacy, after the ancient Greek logician who claimed to have proved that conditions in the real world must necessarily be unchanging. Analysts who attempt to distill the value of an innovation into one simple number that they can compare with other simple numbers are generally trapped by Parmenides’ Fallacy.