EV

In a financial decision making situation, one action will invariably lead to more than one outcome. An expected value analysis helps you take into account the relative likelihood of each possible outcome occuring. By following this approach, you would come out with a decision tree, and it depends on the risk attitude of your directors – whether if they are risk seekers, they will take the maximum result given the most positive scenarios (ie. you expected to have sun for 30 days, and you sell lots of ice-cream), or the minimum result given the worst scenarios (ie. it’s raining every 30 days, and you sell very little ice-cream).

If your directors are risk-neutral however, they want to know the joint weighted average of expected values of all possible outcomes combined, hence removing the variability in the range of the possibilities. (Hence, your total probability is 1.0 or 100%).

The disadvantage of expected value is just that. The weighted average of expected values is not an outcome by itself. It’s a prudent mathematical calculation using the element of subjectivity in determining the probabilities.