Simple Probabilistic Evaluation of Portfolio Strategies

An important part of evaluating portfolio strategies is calculating probability distributions of key value measures, such as the net present value (NPV) of free cash flow. This task can be computationally daunting when the portfolio consists of many businesses or assets, so we have applied an approximate method that quickly captures the location, spread, and tilt (mean, variance, and skewness) of the portfolio distribution. We have also developed displays of the results that nontechnical senior managers can understand readily. These techniques allowed us to interactively explore portfolio strategies with the executive team of a packaging and plastics company comprising 20 businesses and to identify strategies with the potential to more than double NPV with reduced risk. We have since applied these techniques successfully in the pharmaceutical, oil and gas, telecommunications, chemical, and entertainment industries.