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Understanding Sensitivity analysis

Suppose you expect a new product line to start generating a certain amount of annual profit a year from now. What if some variable in the scenario changed? How would that affect your overall evaluation of the investment opportunity?

Sensitivity analysis enables you to ask just this kind of question. It also helps you see the ramifications of incremental changes in the assumptions that underlie a particular projection. A sensitivity analysis shall determines how different values of an independent variable affect a particular dependent variable under a given set of assumptions. This technique is used within specific boundaries that depend on one or more input variables, such as the effect that changes in interest rates (independent variable) has on bond prices (dependent variable).


Example:

Kedai Jam Terlajak Laris (KJTL) is considering investing in a new line of serving carts. Key stakeholders have different assumptions about this investment:

The three different assumptions are

  • Aarif, the vice president of the company’s hanging-racks division, would exercise day-to-day oversight of the new product line. He projects that the new line will generate MYR 60,000 in annual profit for five years.
  • Adi, the company’s CFO, is a bit wary about the investment. That’s because he thinks that Aarif has drastically underestimated the marketing costs necessary to support the new line. He predicts an annual profit stream of MYR 45,000.
  • Luqman, KJTL’s senior vice president for new business development, is optimistic by nature. He’s convinced that the serving carts will practically sell themselves, producing an annual profit stream of MYR 75,000 a year.

KJTL conducts a sensitivity analysis by calculating NPV for the three different profit scenarios:

Yield three different results:

  • NPV for Aarif’s scenario is MYR 2,742.
  • NPV for Adi’s scenario is MYR – 60,443 (a negative NVP).
  • NPV for Luqman’s scenario is MYR 65,927.

If Adi is right, the serving carts won’t be worth the investment, since the NPV for this scenario is significantly negative. But if Aarif or Luqman is right, the investment will be worthwhile marginally so according to Aarif’s profit projections, and very much so according to Luqman’s.

This is where judgment comes into play. If Adi is the best estimator of the three, KJTL’s board of directors might prefer to accept her estimate of the new line’s profit potential. Better still, the company should analyze its marketing costs in greater detail.

Whichever route KJTL takes, the sensitivity analysis will give the board of directors a more nuanced view of the investment and how it would be affected by different assumptions.


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Understanding Internal rate of return analysis

Internal rate of return (IRR) is another analytical method that can help you or your organization to decide whether to make a particular investment. IRR is the rate at which the NPV of an investment equals zero. Like NPV, IRR enables you to consider returns on an annual basis and takes into account the time value of money.

Typically, when the IRR is greater than the opportunity cost (the expected return on a comparable investment) of the capital required, the organization should make the investment under consideration.

The IRR calculation is based on the same algebraic formula as the NPV calculation. With the NPV calculation, you know the desired rate of return, and you’re solving the equation for the net present value of the future cash flows. With IRR, the NPV is set at zero, and you solve the equation for the rate of return.

Your spreadsheet program, app, or calculator will perform IRR calculations for you, just as it will for NPV.

What’s a reasonable rate of return for a business to expect on an investment comparable to the one under consideration? Typically, it’s well above what it could get on a “risk-free” investment, such as a Treasury bill or note (which is usually the benchmark value).

In many instances, companies will set a hurdle rate, which is the minimum rate of return that all investments are required to achieve. In such instances, the IRR of the investment under consideration must exceed the hurdle rate before the company will go forward with it.

 

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Understanding Net present value analysis

The conventional way of calculating ROI has some limitations. For one thing, it doesn’t provide an accurate economic picture of the organization. That’s because it ignores the time value of money, that is the notion that any money received now is worth more than it would be worth in the future.

Also, ROI reflects the rate of return over the life of the investment, not the annual rate of return. This is a problem because you can’t analyze it in terms of annual costs and thus easily compare it with other annual returns.

Therefore in order to compensate for these limitations, you can use a method called net present value(NPV) analysis. NPV is more sophisticated because it takes into account the time value of money.

Time value of money

The time value of money principle states that a dollar you receive five years from now is worth less than a dollar you receive today. The reason: even assuming no inflation or risk, the dollar you get today can be invested somewhere. Assuming a positive return on that investment, that means you’d be able to earn more than a dollar by the fifth year.

When you’re evaluating a potential investment, you need to analyze the income you expect that investment to provide at some point in the future (n). But to do that, you have to express future dollars in terms of current dollars.

Net present value (NPV) and internal rate of return (IRR) calculations help you do that.

These analytical methods are fairly complicated. But most calculators, apps, and spreadsheet programs can make these computations for you easily.

Discount future income

To reflect the time value of money, you have to discount future cash so it’s expressed accurately in today’s dollars. Simply put, a $100 savings today will not be $100 savings five years from now.

NPV calculation

While you can use a calculator or app to calculate NPV, you need to supply the values. An NPV calculation determines the net present value of a series of cash flows according to the following algebraic formula:

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In this formula:

  • Each CF is a future cash flow, so CF1 = cash flow in the first year
  • n is the number of years over which the cash flow stream is expected to occur
  • i is the desired rate of return, or the discount rate

The discount rate in the context of financial analysis means the interest rate earned. In the United States, it refers to the rate at which banks can borrow short-term funds from the Federal Reserve Bank, and is used as a conservative proxy for the cost of funds.

In analyzing an investment, the discount rate is any market interest rate for a “riskless” asset, for example, a Treasury bill, note, or bond, whose maturity matches the investment’s time frame. For a shorter-term investment, an organization might use the rate on a Treasury bill (whose term is under one year). For a longer-term investment, it might opt for the rate on a Treasury note or bond, whose terms run 2-10 years. As a rule, the higher the discount rate, the lower the NPV, all else being equal.

Some organizations ignore the market discount rate and stick with a theoretical or historical discount for analyzing potential investments. Others use the weighted average cost of capital which averages the return of a stock, debt, and preferred stock instead. This option is sometimes used by larger organizations that issue stock.

Another option is using the rate of return for alternative investments.

Finally, consider the element of risk. A riskier investment should have a higher discount rate than a safe investment. Similarly, a longer-term investment should use a higher discount rate than a short-term project.

When you supply the values for each future cash flow, the discount rate, and the number of years, your spreadsheet, app, or calculator will do the rest.

If the NPV of an investment is a positive number, and no other investments are under consideration, the company would do well to pursue the investment. If it’s less than zero, the company should reject the investment. If it equals zero, it’s marginal, therefore, a judgment call.

NPV > 1 (GO)

NPV < 1 (NO GO)

NPV = 1 (MARGINAL)

KJTL example

In considering whether to invest in a new line of serving carts, KJTL assumes a discount rate of 6%. (Surveys show that the discount rate used by companies today varies greatly, from 3% to as much as 7%.) Plugging in the additional data for the calculation—the initial costs and expected returns—yields an NPV of $2,742 for the new line. This NPV is positive, so it suggests that the new line could be an attractive investment for KJTL.

But what about KJTL’s other possible investment , the $100,000 production-line robot? At a discount rate of 6%, the NPV for this investment is $483, which is just barely positive.

If KJTL can afford to make only one of these two investments, it should go with the new serving cart line, because the NPV is much greater.

Companies often purposely set the bar to investment high. So, what would happen if you assumed a discount rate of a more conservative 10% instead of 6% for KJTL? (A discount rate of 10% these days is very high, but is used here for the sake of illustration.) The NPV for the serving carts would be MYR –22,553; for the robot, MYR –$12,368. The serving carts were a better investment than the robot at 6%. At 10%, both investments are bad, but the serving carts are worse. This shows just how much the picture changes when a different discount rate is assumed.

INVESTMENT INITIAL COST RETURN DISCOUNT RATE NPV
Serving Carts MYR 250,000 MYR 300,000

(5 YEARS)

6% MYR 2,742
      10% MYR (22,553)
Robot MYR 100,000 MYR 126,000

(7 YEARS)

6% MYR 483
      10% MYR (12,368)

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Understanding Payback period analysis

With every investment made, you’ll want to know the payback period that is how long it will take to recoup the costs of the investment and start reaping benefit of the investment made.

Payback period can be calculated, divide the total amount of the investment by the annual savings or new revenues expected.


EXAMPLE

KJTL manager expect the $100,000 robot to save the company $18,000 a year. They calculate the payback period as follows:

$100,000 [cost of the robot] ÷ $18,000 [the annual savings] = 5.56 years

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KJTL won’t truly start reaping the benefits of its robot investment for more than five years. But what if the life-span estimates are wrong and the robot wears out soon after five years? The investment now appears a bit riskier certainly more so than an investment with a similar ROI and a payback period of three years.


That’s why it’s important to do the analysis using a range of assumptions. Consult with your organization’s finance department to get a sense of what they would consider conservative and aggressive in their scenario planning. And also research and prepare your business case for the investment in details.

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Understanding Return on investment (ROI) analysis

Smart investments generate valuable returns, such as cost savings, new profit, or appreciation in value of the company’s equity.

Companies use return on investment (ROI) analysis to compare returns on money spent internally with returns available elsewhere, such as investment in government bonds. An investment’s ROI should be reasonably high which is more than the company could expect to get by investing in external opportunities.

ROI analysis has several advantages:

  • It’s easy to convey to upper management.
  • It reminds everyone that wise expenditures pay off financially.
  • It adopts a long-term perspective.
  • It helps you compare different investment options.

Calculating ROI

To calculate ROI, start by figuring the “net return” from an investment, using this formula:

Net return = Total benefits – Total costs

Total benefits can be in the form of savings or additional income. To calculate the ROI, the ratio of the net return to the cost of the investment can be calculated by using this formula:

ROI = Net return ÷ Cost of investment

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Budget for business or organization

budget is the financial blueprint or action plan for an organization, division, business unit, or department. It translates strategic plans into measurable expenditures and anticipated returns over a period of time.

Organizations use different types of budgets for different purposes:

  • An operating budget reflects day-to-day expenses and depreciation (the current portion of capitalized expenses). It typically covers a one-year period. Department, division, and unit managers are usually asked to develop an operating budget for their part of the business.
  • capital budget shows the planned outlays for investments in plant, equipment, and product development. It typically covers longer periods—3, 5, or 10 years. Managers throughout an organization may be expected to prepare or contribute to this type of budget.
  • cash budget addresses expected cash flows during the given forecast period, based on information from the operating and capital budgets. The company’s finance department typically prepares this. This type of budget is essential for ensuring the company has enough cash and credit (liquidity) to meets its expected cash outlays.

The operating budget captures how an organization plans to carry out its overall strategy day to day.

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Other ways to assess organization financial health

Here are two additional ways you can assess an organization’s financial health:

  • Economic value added (EVA)
  • Productivity measures

Economic value added (EVA)

Economic value added (EVA) was introduced as a way to induce employees to think like shareholders and owners. It’s the profit left over after the company has met the cost of capital—that is, after it pays wages to employees, interest to lenders, and a return to shareholders. A positive EVA amount shows that the company is in fact producing an economic profit.

Economic value added (EVA) is also a measure of a company’s financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. EVA can also be referred to as economic profit, as it attempts to capture the true economic profit of a company. This measure was devised by management consulting firm Stern Value Management, originally incorporated as Stern Stewart and Co.

The goal of EVA is to quantify the charge, or cost, of investing capital into a certain project or firm and to then assess whether it generates enough cash to be considered a good investment. The charge represents the minimum return that investors require to make their investment worthwhile. A positive EVA shows a project is generating returns in excess of the required minimum return.

Productivity measures

Productivity measures include sales per employee and net income per employee. These measures link revenue and profit generation information to workforce data. In so doing, they help you assess employees’ effectiveness in producing sales and income. Some analysts classify these measures as operating ratios.

The operating ratio shows the efficiency of a company’s management by comparing operating expense to net sales. The smaller the ratio, the greater the organization’s ability to generate profit if revenues decrease. When using this ratio, however, investors should be aware that it doesn’t take debt repayment or expansion into account.

Operating Ratio Calculation

The operating ratio is calculated by dividing operating expenses by net sales. Operating expenses are essentially all expenses except taxes and interest payments. Occasionally, a company has non-operating expenses as well, which are also deducted. All of these line items are listed on the income statement. Companies must clearly state which expenses are operational and which are designated for other uses.

Points of Consideration

It is important to compare the operating ratio with other firms in the same industry. If a company has a higher operating ratio than its peer average, it may indicate inefficiency, and vice versa. That said, some companies have taken on a great deal of debt, meaning they are committed to paying large interest payments which are not included in the operating expenses figure of the operating ratio. Two companies can have the same operating ratio with vastly different debt levels, so it is important to compare debt ratios before coming to any conclusions. Finally, as with all ratios, it should be used as part of a full ratio analysis, rather than in isolation.

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Business cycle defined

The business cycle refers to the recurring and fluctuating levels of activity that an economy goes through such as expansion, peak, contraction, trough, and recovery. These levels are measured by changes in gross domestic product (GDP), trade activity, and other factors.

Business cycles were once considered quite regular, with predictable duration. But today their frequency, magnitude, and duration vary considerably.

Industries also have business cycles. Different industries respond differently to the macroeconomic forces, so the duration and magnitude of the phases vary.

Investors acknowledge these differences with the terms “cyclical” and “non-cyclical”:

  • Non-cyclical companies enjoy profits regardless of economic fluctuations because they produce or distribute goods and services that are always needed, such as food and power.
  • Cyclical companies’ stock performance depends on a strong economy. Sales are healthy when people have the extra income to spend on these items, but sales decline when the economy declines.

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Valuation Methods

Valuation methods are the methods used by investors and stock analysts when they want to know whether the market price of a company’s share is a good deal relative to the underlying value of the piece of the company the share represents. They also want to know how the company compares financially to its peers.

Different methods of valuation help investors to assess a company’s financial performance in relation to its stock price:

  • Earnings per share (EPS). EPS equals net income divided by the number of shares outstanding. This is one of the most commonly watched indicators of a company’s financial performance. If it falls, it will likely take the stock’s price down with it.

    In other words, EPS is the portion of a company’s profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company’s profitability.

EPS is calculated as:

EPS = (Net Income – Dividends on Preferred Stock) / Average Outstanding Shares

  • Price-to-earnings ratio (P/E). The P/E ratio is the current price of a share of stock divided by the previous 12 months’ earnings per share. It’s a common measure of how cheap or expensive a stock is relative to earnings. 

In order words, the price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings. The price-earnings ratio is also sometimes known as the price multiple or the earnings multiple.

The P/E ratio can be calculated as:

Market Value per Share / Earnings per Share

  • Price-to-book ratio. This is the current market price of a share of stock divided by a stock’s book value per share. (To calculate the book value, subtract the preferred stock total from total equities, and then divide the result by the number of shares outstanding)

The Price to Book Ratio – P/B Ratio is used to compare a firm’s market to book value and is calculated by dividing price per share by book value per share.

Also known as the “price-equity ratio”.

Calculated as:

P/B Ratio = Market Price per Share / Book Value per Share

where Book Value per Share

= (Total Assets – Total Liabilities) / Number of shares outstanding

A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company. As with most ratios, be aware that this varies by industry.

This ratio also gives some idea of whether you’re paying too much for what would be left if the company went bankrupt immediately.

  • Growth indicators. When a company grows (in sales, profitability, or earnings per share), it can provide increasing returns to its shareholders and opportunities for employees. In industries with long business cycles (like oil and gas), analysts measure a company’s growth over numerous years. In industries with short cycles (like the internet), analyses measure growth over fewer years maybe even just one.