Here is an excerpt from a classic article written by Clayton M. Christensen, Stephen P. Kaufman, and Willy C. Shih for Harvard Business Review (2008) and the HBR Blog Network. To read the complete article, check out the wealth of free resources, obtain subscription information, and receive HBR email alerts, please click here.

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For years we’ve been puzzling about why so many smart, hardworking managers in well-run companies find it impossible to innovate successfully. Our investigations have uncovered a number of culprits, which we’ve discussed in earlier books and articles. These include paying too much attention to the company’s most profitable customers (thereby leaving less-demanding customers at risk) and creating new products that don’t help customers do the jobs they want to do. Now we’d like to name the misguided application of three financial-analysis tools as an accomplice in the conspiracy against successful innovation. We allege crimes against these suspects:

o The use of discounted cash flow (DCF) and net present value (NPV) to evaluate investment opportunities causes managers to underestimate the real returns and benefits of proceeding with investments in innovation.

o The way that fixed and sunk costs are considered when evaluating future investments confers an unfair advantage on challengers and shackles incumbent firms that attempt to respond to an attack.

o The emphasis on earnings per share as the primary driver of share price and hence of shareholder value creation, to the exclusion of almost everything else, diverts resources away from investments whose payoff lies beyond the immediate horizon.

These are not bad tools and concepts, we hasten to add. But the way they are commonly wielded in evaluating investments creates a systematic bias against innovation. We will recommend alternative methods that, in our experience, can help managers innovate with a much more astute eye for future value. Our primary aim, though, is simply to bring these concerns to light in the hope that others with deeper expertise may be inspired to examine and resolve them.

Misapplying Discounted Cash Flow and Net Present Value

The first of the misleading and misapplied tools of financial analysis is the method of discounting cash flow to calculate the net present value of an initiative. Discounting a future stream of cash flows into a “present value” assumes that a rational investor would be indifferent to having a dollar today or to receiving some years from now a dollar plus the interest or return that could be earned by investing that dollar for those years. With that as an operating principle, it makes perfect sense to assess investments by dividing the money to be received in future years by (1 + r)n, where r is the discount rate—the annual return from investing that money—and n is the number of years during which the investment could be earning that return.

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.

It’s hard to accurately forecast the stream of cash from an investment in innovation. It is even more difficult to forecast the extent to which a firm’s financial performance may deteriorate in the absence of the investment. But this analysis must be done. Remember the response that good economists are taught to offer to the question “How are you?” It is “Relative to what?” This is a crucial question. Answering it entails assessing the projected value of the innovation against a range of scenarios, the most realistic of which is often a deteriorating competitive and financial future.

The projected value of an innovation must be assessed against a range of scenarios, the most realistic of which is often a deteriorating competitive and financial future.

The second set of problems with discounted cash flow calculations relates to errors of estimation. Future cash flows, especially those generated by disruptive investments, are difficult to predict. Numbers for the “out years” can be a complete shot in the dark. To cope with what cannot be known, analysts often project a year-by-year stream of numbers for three to five years and then “punt” by calculating a terminal value to account for everything thereafter. The logic, of course, is that the year-to-year estimates for distant years are so imprecise as to be no more accurate than a terminal value. To calculate a terminal value, analysts divide the cash to be generated in the last year for which they’ve done a specific estimate by (r−g), the discount rate minus the projected growth rate in cash flows from that time on. They then discount that single number back to the present. In our experience, assumed terminal values often account for more than half of a project’s total NPV.

Terminal value numbers, based as they are on estimates for preceding years, tend to amplify errors contained in early-year assumptions. More worrisome still, terminal value doesn’t allow for the scenario testing that we described above—contrasting the result of this investment with the deterioration in performance that is the most likely result of doing nothing. And yet, because of market inertia, competitors’ development cycles, and the typical pace of disruption, it is often in the fifth year or beyond—the point at which terminal value factors in—that the decline of the enterprise in the do-nothing scenario begins to accelerate.

Arguably, a root cause of companies’ persistent underinvestment in the innovations required to sustain long-term success is the indiscriminate and oversimplified use of NPV as an analytical tool. Still, we understand the desire to quantify streams of cash that defy quantification and then to distill those streams into a single number that can be compared with other single numbers: It is an attempt to translate cacophonous articulations of the future into a language—numbers—that everyone can read and compare. We hope to show that numbers are not the only language into which the value of future investments can be translated—and that there are, in fact, other, better languages that all members of a management team can understand.

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Here is a direct link to the complete article.

Clayton M. Christensen is the Kim B. Clark Professor of Business Administration at Harvard Business School. A former CEO of Arrow Electronics, Stephen P. Kaufman (skaufman@hbs.edu) is a senior lecturer at Harvard Business School, in Boston, and has been a director of six public and four private companies. Willy C. Shih is the Robert and Jane Cizik Professor of Management Practice in Business Administration at Harvard Business School.