Monday, April 23, 2007

The Value of Scenario Planning

A standard part of the investment process is to identify a business model's key variables and to generate scenarios that test their impact on revenue and cash.

Sure signs of a thoughtful management team are:
  1. the ability of the management team to articulate the material business drivers in the model
  2. to test the impact of the variables on material financial metrics
  3. to sanity check the assumptions with market comps - i.e. not to base the business on a black swan outcome
  4. to focus the management team and company KPIs on the identified variables.
  5. the inclusion of scenario analyses in investor presentations
A very effective means of testing variables is the data table, which allows one to test how different input variables affect the results of a given formula.

The attached example illustrates the value of data tables in analyzing
  • the impact of CPM rates and
  • revenue share on an ad network.
The analysis takes the company's forecast and key assumptions and calculates the required page views to hit the plan. The requried page views are then compared to known market comps to test for "black swan" risk. Finally, with CPM rates and revenue share the key variables, a data table tests the the impact of a range of CPM rates and revenue share splits on the page views required to hit projected 2008 revenue.

For example, the analysis illustrates that for the company to hit 2008 revenue
  • at a $5 cpm, 20% revenue share
  • the company needs to grow monthly impressions to
    • 333.33m PVS/month
    • 6.67x current traffic
    • 56% of MSNBC's current monthly traffic
  • However, at a $2 CPM and 10% revenue share
    • the company needs to grow monthly impressions to
    • 1.666bn PVS/month
    • 33.33x current traffic
    • 282% of MSNBC's tarffic
    • Ie, the model begins to look precarious and "black swan-like, ie possible but highly improbable"
In summary, the effective modeling of scenarios helps to highlight the impact of key variables on the business, helps communicate the maturity of the management team's thinking, and frames the sanity (relative to market) of the plan in question.