How do you assess an investment?
There are many ways to value a company or an investment. This article will explain three core methodologies. They are the net present value technique, the Average rate of return, and the payback method.
The payback method is one of the simplest investment appraisal methodologies. Often criticised for being too simple! It asks a simple question: how long does will my investment earn my money back?
The calculation is fairly straightforward. You estimate the annual returns of the investment. You are interested in how much bottom line cash (after all cash outflows) you will be entitled to.
The payback method sums these annual returns in chronological order. Once the sum of the returns is greater than your initial investment then you know how long it will take for your investment to pay you back.
As an example, assume that an investment will cost you £1,000 up front. However, after all of your expenses and outgoings your bottom line positive cash flow each year will be as follows: at the end year 1 you will gain £500, at the end of year 2 it will be £400 and at the end of year 3, £200.
In the above example, the investment pays back the initial £1,000 somewhere between years 2 and 3. To be more precise, the payback would estimate a return in about 2.5 years time.
One of the key drawbacks to the payback method is that it doesn't make any assessment as to how good the investment is. There are no comparisons in percentage terms of how the investment has done. The calculation only focuses on how long it takes to get your money back but as an investor you should be interested in outperformance, and not only concerned with getting your money back.
Average rate of return
The average rate of return is a significant improvement on the payback method. It starts to assess how good the average performance of an investment is. This allows comparisons to be made between alternative investment proposals.
The average rate of return (ARR) is a straight forward formula:
ARR = ( net profits over the life of the investment including the initial outlay / number of years of the investment ) / initial investment
In our previous example the formula would calculate the following:
ARR = ( £100 / 3 ) / £1,000
As a percentage this would suggest that the average rate of return is 3.6% per annum. The percentage immediately improves on the payback method as it gives an indication as to how good the investment is, allowing for comparison. There will exist many investments that will require a longer payback period but crucially with a higher average rate of return per year.
One major drawback to the average rate of return is the lack of consideration for the time value of money. Money depreciates in value over time. £1,000 today is worth far more than £1,000 in ten years time. This is due to various reasons.
Money is worth more today simply due to the eroding nature of inflation over time. Secondly, we could invest the £1,000 today to earn interest over time, making it far more valuable to have the cash today. Finally, there is far less risk taking the money today as there is less of a guarantee that the money will still be available in ten years time versus being given the money today.
Net present value methodology
The net present value (NPV) methodology quantifies the returns from an investment taking the time value of money into account. It is generally considered a requisite to understanding value.
Key to understanding net present value is the use of the discount factor. This is a percentage that is used to reduce cash flows in the future into their present day value.
A discount rate is normally converted into a discount factor. You multiply the cash returns from the investment by the discount factor each period in order to get a truer value of the cash flows in today's money. For example, a discount rate of 5% should be converted into discount factors as follows:
Year 1: 1 * 0.95 = 0.95
Year 2: 0.95 * 0.95 = 0.9025
Year 3: 0.9025 * 0.95 = 0.8574
Year 4: 0.8574 * 0.95 = 0.8145
And so on and so forth.
In order to calculate the net present value we take each of these discount factors and multiply them by the cash flow earned in that period. For example, if £1,000 was earned in year 1 then the present value of that £1,000 is only £950. You continue to do this for each year of cash flows and then minus off the initial investment. Whatever that figure is, this is your net present value of the investment.
The result will be an amount. Should this amount be positive then it's an investment worth considering. Net present values amounts can be compared in order to consider alternative investments. Invest in the proposal that offers the higher net present value. Simple.
Net present value, whilst generally considered stronger than the other appraisal techniques is not fool proof and has many flaws. However, I will save these for another article.