362  Analyzing the Results an EBITA margin of 14 percent and revenue growth of 3 percent (among other forecasts), the company is currently valued at $365 million. The curve drawn through this point represents all the possible combinations of EBITA margin and revenue growth that lead to the same valuation. (Economists call this an isocurve.) To increase the valuation by 25 percent, from $365 million to $456 mil- lion, the organization needs to move northeast to the next isocurve. Using this information, management can set performance targets that are consistent with the company’s valuation aspirations and competitive environment. When performing sensitivity analysis, do not limit yourself to changes in financial variables. Check how changes in sector-specific operational value drivers affect the final valuation. This is where the model’s real power lies. For example, if you increase customer churn rates for a telecommunications company, does company value decrease? Can you explain with back-of-the- envelope estimates why the change is so large or small? Creating Scenarios Valuation requires a forecast, but the future can take many paths. A govern- ment might pass legislation affecting the entire industry. A new discovery could revolutionize a competitor’s product portfolio. Since the future is never knowable, consider making financial projections under multiple scenarios.2 The scenarios should reflect different assumptions regarding future macro- economic, industry, or business developments, as well as the corresponding strategic responses by industry players. Collectively, the scenarios should cap- ture the future states of the world that would have the most impact on value creation over time and a reasonable chance of occurrence. Assess how likely it is that the key assumptions underlying each scenario will change and assign to each scenario a probability of occurrence. When analyzing the scenarios, critically review your assumptions con- cerning the following variables: • Broad economic conditions. How critical are these forecasts to the results? Some industries are more dependent on basic economic conditions than others are. Home building, for example, is highly correlated with the over- all health of the economy. Branded food processing, in contrast, is less so. • Competitive structure of the industry. A scenario that assumes substan- tial increases in market share is less likely in a highly competitive and 2 Overconfidence is a well-known behavioral bias. Embracing uncertainty through the use of scenario analysis helps mitigate overconfidence. For more on overconfidence and valuation, see J. Lambert, V. Bessiere, and G. N’Goala, “Does Expertise Influence the Impact of Overconfidence on Judgment, Valu- ation and Investment Decision?” Journal of Economic Psychology 33, no. 6 (December 2012): 1115–1128. Creating Scenarios  363 concentrated market than in an industry with fragmented and ineffi- cient competition. • Operating capabilities of the company. Focus on capabilities that are neces- sary to achieve the business results predicted in the scenario. Can the company develop its products on time and manufacture them within the expected range of costs? • Financing capabilities of the company. Financing capabilities are often im- plicit in the valuation. If debt or excess marketable securities are exces- sive relative to the company’s targets, how will the company resolve the imbalance? Should the company raise equity if too much debt is projected? Should the company be willing to raise equity at its current market price? Complete the alternative scenarios suggested by the preceding analyses. The process of examining initial results may well uncover unanticipated ques- tions that are best resolved by creating additional scenarios. In this way, the valuation process is inherently circular. Performing a valuation often provides insights that lead to additional scenarios and analyses. Exhibits 17.4 and 17.5 provide a simplified example of a scenario approach to discounted-cash-flow (DCF) valuation. The company being valued faces great uncertainty because of a new-product launch for which it has spent consider- able time and money on research and development (think of a major launch such as when Tesla introduced its economically priced Model 3 in 2019). If the new product is a top seller, revenue growth will more than double over the next few years. Returns on invested capital will peak at above 20 percent and remain above 12 percent in perpetuity. If the product launch fails, however, growth will continue to erode as the company’s current products become ob- solete. Lower average selling prices will cause operating margins to fall. The company’s returns on invested capital will decline to levels below the cost of capital, and the company will struggle to earn its cost of capital in the long term. Exhibit 17.4 presents forecasts on growth, operating margin, and capital efficiency that are consistent with each of these two scenarios. Next, build a separate free cash flow model for each set of forecasts. Al- though not presented here, the resulting cash flow models are based on the DCF methodology outlined in Chapter 10. Exhibit 17.5 presents the valuation results. In the case of a successful product launch, the DCF value of operations equals $5,044 million. The nonoperating assets consist primarily of noncon- solidated subsidiaries, and given their own reliance on the product launch, they are valued at the implied NOPAT multiple for the parent company, $672 million. A comprehensive scenario will examine all items, including nonop- erating items, to make sure they are consistent with the scenario’s underlying premise. Next, deduct the face value of the debt outstanding at $2,800 million