A Holistic Approach: DNPV
To solve the time-bias conundrum, a robust and holistic valuation method termed DNPV (decoupled net present value) is introduced. DNPV recognizes that cash flows are uncertain and their variability are directly connected to sources of risk such that risk exposure (i.e., the likelihood of an event occurring times the potential loss) can be consistently and transparently estimated over time. The ideas behind DNPV were born from a National Science Foundation research grant entitled “Environmental Risk Management and Quantification Using Real Options,” which involved development of an integrated framework using option pricing theory to estimate the value of contaminated properties. The DNPV method is capable of assessing the ever changing investment risks, allowing long-term investments to finally be on equal footing with short-term opportunities so we can begin to develop the projects that will do the most good.
The ability of DNPV to consistently translate technical assessment of physical risks into financial terms and integrate both market and non-market risks allows financial practitioners to work collaboratively with risk management practitioners and technical experts to evaluate the influence of different risk management techniques (e.g., avoidance, reduction, mitigation, transfer, and retention) on project risk and select risk management techniques that are deemed optimal for the project. As a result, DNPV allows integration of risk quantification, asset/liability valuation and risk management with applied engineering, environmental science and global industry knowledge. Independent of investors' risk appetite, each project has a unique risk signature. Once all project risks are identified, probability distributions for each of the identified risks and the associated risk exposure are calculated, the investment risk signature (e.g., an implied risk adjusted discount rate) that is consistent with the investment horizon and probability distributions can be calculated rather than heuristically selected. The project risk signature can be used as a proxy for project risk and compared with the project's IRR as well with the investors weighted average of capital cost (WACC).
The Cost of Risk Concept
The proposed DNPV method addresses the discount rate issue by separating the time value of money from the risk associated with an investment and, irrespective of their source (i.e., market and non-market), considering the investment downside exposure (i.e., the cost of risk) as an investment cost. The downside exposure concept eliminates the need to select a risk adjusted discount rate because risks are already accounted for in the cash flows as a cost to the project. DNPV classifies risks into two categories: revenue risk and expenditure risk. These downside risks are associated with obtaining lower revenues and/or incurring higher expenses than originally expected. The treatment and inclusion of these risk exposures as negative cash flows invariably results in lower cash flows. Because the risks associated with an investment are accounted for by these negative cash flows, the decoupled (i.e., de-risked) cash flows (cash flows - cost of risk) can be discounted using risk free rates.
Furthermore, although the DNPV method is based on assessments of downside exposures, it can also be interpreted as a call option (i.e. the upside potential) minus the risk exposure. Thus, using real options concepts, DNPV can be used not only as a valuation tool but also to value managerial flexibility in an intuitive, consistent, transparent and robust manner. More importantly, all these can be done without the deleterious time-bias effect introduced by valuation methods based on risk adjusted discount rates. The theoretical and empirical foundation of DNPV has been presented in seminal publications in peer-reviewed journals and the concept is gaining acceptance as evidenced by the work performed by academic research institutions (see listings under Collaborators).
Combining Standard Valuation Tools with DNPV
Although some risks are common to investments in a given sector, not all such investments face the same risks. For instance, power plants may be subject to the same market risks on the revenue side if selling electricity on the spot market; however, they may be subject to different non-market risks depending upon the type of power plant (e.g., amount of water for run-on river hydropower plants, amount of winds for wind-operated plants). Standard valuation methods do not have a consistent procedure to capture the changing technical risk profile of an investment. The classical NPV method is a top-down approach that resulted from the process of acquiring capital and mandating that all investments must earn its weighted average cost of capital (WACC). As such, standard methods are more concerned with the source of funding than the project itself (i.e., it is exogenous to the project) with the selected discount rate representing the investor's desired return rather than the project risk. On the contrary, DNPV is a bottom-up approach that first identifies the investment risks and then integrates these risks in the project valuation (i.e., it is endogenous to the project). Taking advantage of investors' knowledge of standard valuation tools, DNPV can be used as a complementary valuation method and the results of DNPV and NPV combined in a two-prong approach to provide significantly greater insight on potential investments opportunities. This approach represents a new way of thinking about financial measurement associated with an investment decision process. The two-prong approach gives investors a new perspective of the investment’s financial and risk performance.