What is the chance I might lose money on this deal?

"What is the chance I might lose money on this deal?" My client asked me this question after we had completed the valuation of the acquisition target, and it looked like we were in a position to get a bargain. Conventional valuation models don't really answer that question even through it is entirely valid. He wanted to pay a fair price for the business, but was also concerned about losing money by having to invest additional funds into it after acquiring it.

So, we expanded the scope of the project to include a Value-at-Risk analysis which answers the question, "Assuming the worst-case scenario has a (X)% chance of happening, how much money do I lose if that occurs?" X can be anything.

VaR is usually (but not always) performed using some sort of simulation model. My go-to tool for this is a Monte Carlo simulation. Working closely with the client, we built a detailed model incorporating 20 or so risk variables and performed data analysis to determine those variables' variation (standard deviation) and distribution (shape of outcomes, such as a bell curve).

We then ran the model to simulate 100,000 different cash flow outcomes and varied the percentage threshold for the loss scenario. This was seven years ago, so it took an hour for a state-of-the-art computer to run one simulation. In fact, I had to buy more memory for the computer to keep it from crashing, so it took a few days to complete the analysis.

The result was that there was a 25% chance that my client, the buyer, would have to invest at least $1 million in the next five years to keep the company afloat. The bargain turned into a deal-breaker, and my client walked away.

By asking a simple question, we were motivated to find the tools to answer it and achieved a depth of financial analysis that we don't see very often. As a result, my client was much better informed about making critical decisions and managing his risk.

Can we help you understand your risk quantitatively?