What good is an analysis without knowing what to measure? Even the best analysts can easily get lost in the numbers and variables and unintentionally reach outcomes that are untrue or inaccurate. Over the next five weeks, we will introduce a handful of general guidelines that will help you to both define and measure this often-elusive phenomenon we call success. Combining these practices will help avoid misguided results and reach higher success.
In the back of our minds, we all have utilities assigned to the options we face. With these utilities, we usually make our decisions with a subconscious cost and benefit analysis. In the business world, the same approach occurs. Here, however, goals, assumptions, and utility functions should be well defined.
Simply put, a well-defined decision-making process gives employees the confidence that management knows what it’s doing. Establishing a body of measurements and rules, along with decision protocols, results in increased performance, focused outcomes, and consistency. Perhaps more importantly, poor decisions are less frequent and even measurable if the system is set up appropriately. Spending the time to build, maintain, and implement this system benefits and supports all facets of a business organization.
POST 1: MEASURE THE RIGHT THING: INTRODUCTION OF 4 MAIN FINANCIAL MEASURES
A good place to begin is by looking at future cash flow and how it plays a role in the decision-making process. To that end, let’s define four financial measures that all deal with such cash flows.
Net Present Value (NPV): following the concept of time value of money, NPV represents the aggregate value of all future cash flows (sometimes past cash flows too!) in present value, usually the currency of interest. Time value of money says that $100 today is worth more than $100 tomorrow or a week from now. So, the NPV of $100 a week from now is something less than $100 today. In order to calculate NPV, we need to know the discount rate in the market i.e. the interest rate that dictates the time value of money. This rate is also called the opportunity cost of capital. For example, if annual interest rate is 10%, then the NPV of a $110 in a year from now is $100. Here’s the calculation:
$110 a year from now is actually sum of NPV (the amount of money a year before that) and the accumulated interest rate, which is 10% of that NPV. So, 110% of NPV is equal to $110. Hence, NPV is $100.
Given the same assumption, if you want to choose between two projects whose payoffs are respectively $105 today and $110 a year from now, looking at their NPVs, you would be better off choosing the first project as NPV ($105 today) > NPV ($110 a year from now) = $100 today.
We could also extrapolate the notion of NPV to things other than currency. For instance, to a fisherman, NPV is calculating the value of the fish caught over time, but based on what they are worth today, i.e. a fish caught today is worth more than a fish that has not been caught yet. The longer he has to wait, the less valuable it becomes. This also illustrates the concept of risk, because we are not certain we will catch a fish. We can only estimate this based on our past experience of how successful we have been catching fish.
Return on Investment (ROI): There are two types of ROI: simple ROI and discounted ROI. Simple ROI is basically the ratio of net profit to net cost or investment. As you might have guessed already simple ROI does not account for time value of money. This is where discounted ROI becomes important. If we calculate the NPV of our investments for a typical project and compare that with the NPV of our payoffs for that project, we could calculate the return on our investments in present terms (i.e. discounted ROI. Basically, discounted ROI is 100 x NPV (Payoffs)/NPV (Investments). A manager could face two different investment opportunities in an occasion: investing $45 today in order to receive $110 two years from now vs. investing $40 today in order to receive $100 a year from now. Given the 10% discount rate, the NPV of gains from the two projects is the same and equal to $90.91. However, the value added of the second project should be higher as the amount of investment is lower for that. Hence, the discounted ROI for the first project is (90.91-45)/45 = 102%, and that for the second project is (90.91-40)/40 = 127%. Clearly, the second project is the better option to choose. Note that NPV and discounted ROI are two sides of the same coin when it comes to decision making. They are both referring to the profitability of projects (i.e. how much money could we extract from each currency unit of our investment). In fact, when it comes to using discounted ROI as a measure to calculate profitability, when the NPV of investments are the same, we only have to compare the NPV of gains from the projects of interest.
Returning to our fisherman example, ROI is calculating the value of all of the fish vs. the cost of the fishing pole, the bait and the fishing permit.
Profitability Index (PI): Looking at the definition of PI, we would see that PI and discounted ROI essentially contain the same amount of information. Profitability index is the present value of cash inflow divided by the present value of cash outflow, which accounts for the time value of money for each. In other words:
PI = Discounted ROI/100 + 1
PI is useful for ranking projects based on the cost and benefit of each project. It is a ratio of the benefit vs. the cost. A profitability index of 1.0, which is discounted ROI of zero, is therefore the equilibrium point for making enough money on a present value basis to cover the cost of the project. The higher the profitability index, there is more present value cash vs. the cost of the project.
When working on complex projects with past and future cash flows, it is not suggested to use the simple ROI at all since it does not account for the time value of money. Thus, PI and discounted ROI are preferred to simple ROI. Thus, in summary we can compare the profitability Index vs. ROI as follows:
- Simple ROI does not take into account the time value of money. An investment with a 90% return looks much better than an investment with a 10% return. However, what if it took 20 years to get a 90% return vs. 1 year to get a 10% return? In this case the simple ROI is too simple a measure to make a comparison.
- ROI subtracts costs and multiplies by 100 to turn it into a “rate”. The profitability index does not subtract the costs in the numerator and does not multiply by 100 so represents an index over the cost. There a 1.0 becomes a 100% ROI, because costs have been subtracted.
- If you spent $100 and recovered it a year later then the simple ROI would be 0%. In contrast, the profitability index might be 0.9, showing that you did not get your money back. This is due to the time value of money.
- Profitability index measures the present value of the fish (similar to the NPV), but divides it by the cost. If greater than 1.0 then you caught enough fish to pay for the fishing pole, the bait and the fishing permit.
Internal Rate of Return (IRR): Unlike the two previous measures that calculate profitability, IRR calculates efficiency. Imagine you calculate the NPV of the gains in a project for a range of interest rates as well as that of the expenses (investments) for the same range. The interest rate that sets those two NPV values equal is IRR. When you compare two projects using IRR, the one with higher IRR is the more efficient one. For instance, if you invest $100 today and gain $110 in a year from now, the interest rate that set the NPV of $110 a year from now equal to $100 (NPV of your investment) is 10%. Hence, the IRR in that case is 10%. Now, if we had a second project that requires $1,000 worth of initial investment to gain $1,050 in a year after the investment, then the IRR will be 5%. In case of having a 2% discount rate in the market, the NPV of the first project’s gain is $107.84, and that for the second one is $1,029.41. Thus, the second project is more profitable than the first one as $1,029.41-$1,000 > $107.84-$100. However, the first project is more efficient (i.e. if we could invest $1,000 in the first project with the same IRR, then having the same amount of initial investment as the second project and being more efficient make the first project even more profitable). Back to our fisherman example, IRR is the measure of speed, i.e. how fast we are catching fish measuring the growth rate of our pile of fish.
IRR: NPV (x, Investments) = NPV (x, Returns); solve for x
The three measures mentioned above are examples of choosing the right measure to assess success or weigh your options in decision making process. Is your success dependent on the amount of profit you gain (NPV) or on how fast you could gain the first dollar from your investment (IRR)? The answer to that question will lead you to the right measure. They both could be applicable to any business or industry. Sometimes, for a manager short term gains and value creation are important and the focus; like situations where that manager needs fast cash flow come in to the business. That is a place to use IRR to weigh your options. On the hand, you might want to choose among different options, but there is no immediate need for cash in hand. So, you could freely invest your money in the project that would give you the highest amount of profit. Then, you should look at the NPVs of your options.
NEXT WEEK’S POST: HOW TO PICK THE RIGHT MEASURING TOOL