The process of making decisions is both an art and a science. A decision-maker’s intuition is invaluable. Articulating a strategy, employing strategic thinking and choosing a path are equally as important as determining the value of a decision. Yogi Berra once said quite cavalierly, “When you come to a fork in the road, take it!”
However, I would like to speak about the science component of decision-making: the quantitative side to valuing and measuring decisions. I am continually amazed by the lack of rigor and discipline of both large and small organizations.
To begin, let’s take a scenario: Assume that an organization has multiple lines of business (both manufacturing and non-manufacturing) across varied industries and is considering 1) upgrading its equipment, IT systems and facilities for one or more lines; 2) divesting a line of business; 3) acquiring one of several target companies to enhance or begin a new line of business; or 4) doing nothing.
(By the way, this article can apply to acquisition and divestiture decisions, whether publicly traded or privately owned.)
How can these vastly different scenarios be measured and what quantitative tools should be employed? How can risk and return be quantified and integrated with a firm’s capital budgeting process? Does the owner/management use a payback method, return on investment, return on invested capital, net present value (NPV), internal rate of return (IRR), cost of equity, weighted average cost of capital (WACC) or equity, asset or project betas?
Decide How You Want to Forecast Your Future
To simplify, at every decision’s core (at least the quantitative consideration) is a stream of future cash flows. That decision will either increase or decrease those cash flows (return) and the level of volatility/probability (risk) of the possible outcomes against those that will occur. Certain options will be more similar than others (i.e., more highly correlated with one another, with a particular industry and in relation to the overall market).
Capital budgeting is the process of identifying and selecting the best projects/decisions in which to invest the resources of the firm based on each scenario’s perceived risk and return. This involves creating a forecast that encompasses an option or a range of options and making probability-weighted assumptions about the impact a decision has on the future cash flows of a business or line of business. The return is the change in future cash flows relative to the amount of cash that is expended. The risk is normally quantified in the form of interest rates that take into account volatility and the time value of money – the length of time a cash investment is tied up before a return is generated. A discounted cash flow model (DCF) not only calculates future cash flows, but also assigns (discounts) a lower value to future vs. current cash flow.
One of the most standard measures of performance used is return on investment (ROI). ROI does not account for opportunity cost or the time value of money, but it is helpful in determining what was gained from an investment and comparing the efficiency across a number of different investments. Another basic measure is the payback period, which illustrates how long it takes to recoup the cost of an investment or the length of time to reach a breakeven point. It is also helpful in comparing against different investments and it gives a sense of opportunity cost based on time to recover, but it does not consider discounting future cash flows based on the time value of money. Net Present Value (NPV), which is used to analyze the profitability of a projected investment or project, calculates the difference between the present value of future cash inflows and the present value of cash outflows over a period of time. This measure is more sophisticated because it uses a discount rate to value future cash outflows and inflows less highly than those that are more current. It is also helpful at taking into account expenditures and inflows that occur at different and multiple times. This discount rate is often referred to as a hurdle rate and can be used as a benchmark for opportunity cost. The internal rate of return (IRR) is the discount rate that makes the net present value of all cash flows equal to zero. Therefore, it is a time-weighted breakeven point expressed in the form of an interest rate. The higher a project’s IRR, the more desirable it is to undertake.
A company’s cost of capital is the required return necessary to make a capital budgeting project worthwhile. All equity firms can discount their “standard” investment projects at the cost of equity, and managers can estimate their cost of equity using the capital asset pricing model (CAPM). That discussion is for another time. The cost of equity is influenced by both operating leverage as well as financial leverage. Many companies use a combination of debt and equity to finance their businesses, and the overall cost of capital is derived from the weighted average cost of all capital sources, or the weighted average cost of capital (WACC). The WACC and CAPM are connected in that the cost of debt and equity are driven by the betas of the firm’s debt and equity. Beta is a coefficient (and a building block of discount rates) that measures the volatility of an individual stock in comparison to that of the entire market. Statistically speaking, beta represents the slope of the line through a regression of data points from an individual stock’s returns against those of the market.
Learn to Understand the Uncertainty
When a firm wants to make an “unusual” investment or an investment outside its normal line of business, it should try to estimate the asset beta for that industry using pure play firms. To estimate the asset beta for a different industry, the equity beta of a pure play firm must first be unlevered for debt used by that pure play firm. Then the beta can be used to re-lever for the existing firm’s capital structure and usage of debt.
There are a variety of management tools used to assist in understanding the sources of uncertainty of a project’s cash flows. These tools include break-even analysis (based on modeling linear relationships), sensitivity analysis, scenario analysis, Monte Carlo simulation and decision trees. Break-even analysis examines linear revenue, variable and fixed costs to determine cost/volume/profit relationships. Sensitivity analysis allows for the exploration of the importance of individual assumptions and variables concerning a project’s net present value by determining the impact of changing one variable while holding all other factors constant. Scenario analysis is a more complex variation of sensitivity analysis that provides for calculating the net present value when a whole set of assumptions changes in a particular way. Monte Carlo simulation is a sophisticated analysis that provides for calculating the net present value when provided a range or distribution of potential outcomes (i.e., running a very large number of scenario analyses and calculating a statistical distribution). Decision trees are a representation of the choices that managers/business owners face over time with regard to a particular investment and allows for probability weighting individual decisions at incremental steps.
One limitation to NPV is that it may either understate or overstate a project’s value depending on whether the proposed investment creates or destroys future options. These may include expansion, abandonment, follow-on investment or flexibility options, which may include input, output/operating or capacity flexibility. Thus, NPV misses the value of management’s ability (or inability) to alter an investment’s value in response to internal/external factors that may occur after an investment is made.
Remember Yogi Berra’s quote about taking the fork in the road? He actually had a long driveway that led to his house and forked with both paths converged at his front lawn. Simply making choices based on intuition does not work in business. Knowing how to apply quantitative discipline to the decision-making process can be make-or-break. Nevertheless, business acumen includes combining the science with the art – that is, experience can provide a well-honed intuition balanced with quantitative measurement and support involving investment decisions over a number of years and across multiple industries.
About the Author:Wayne Jones is a licensed CPA, licensed investment advisor and is pursuing a master’s degree in professional counseling at Liberty University. Before joining Pendleton Street Advisors, he was a vice president at Blue Cross Blue Shield for 15 years and held roles in Corporate Development, Mergers & Acquisitions and corporate finance and accounting. In these roles, Wayne gained valuable expertise working on buyer side acquisitions within the insurance, technology and health sectors while using business valuation, consulting and planning skills.