> Suppose you could build the product for $50M with a 50% chance of significant delays or failure. Then the upper bound of what you’d rationally pay to acquire would be $100M.
Am I the only one who thinks cdixon is slightly off here (except Chris with his reference to sophistication)? But what is the right way to calculate?
To simplify ignore the risk of delay for now (so 50% is risk of failure). Also assume the risk of acquisition is 0%. Then you have three outcomes: 1) acquisition, 2) internal success and 3) internal failure. In economic terms 1 means you gain $500M - X where X is the acquisition cost, 2 means that you gain $450M and 3 means that you lose $50M.
In this oversimplification I would say that the expected outcome of internal development is a gain of $200M (50/50 chance of $450M win or $50M loss). It would be rational to pay X < $300M since that would give you a certain gain of more than $200M.
Right? This is of course also lacking in sophistication but I have a feeling it touches on the angst that drives acquisition valuations up... :)
Am I the only one who thinks cdixon is slightly off here (except Chris with his reference to sophistication)? But what is the right way to calculate?
To simplify ignore the risk of delay for now (so 50% is risk of failure). Also assume the risk of acquisition is 0%. Then you have three outcomes: 1) acquisition, 2) internal success and 3) internal failure. In economic terms 1 means you gain $500M - X where X is the acquisition cost, 2 means that you gain $450M and 3 means that you lose $50M.
In this oversimplification I would say that the expected outcome of internal development is a gain of $200M (50/50 chance of $450M win or $50M loss). It would be rational to pay X < $300M since that would give you a certain gain of more than $200M.
Right? This is of course also lacking in sophistication but I have a feeling it touches on the angst that drives acquisition valuations up... :)