In Jonathan Byrnes’ previous blog, part one of a discussion on strategic investments, he discussed two critical questions that are at the heart of a sound investment assessment. This continues that discussion and covers the topics of which measures a company should use to assess potential investments.
Let’s return to the question of the strategic investment in part one of this blog. Here the investment was being judged by the current cost of capital, a measure that is backward-looking by definition because it reflects the current portfolio of investments made in prior periods. Yet the investment in question was being made to have a quantum effect on the company’s future.
For a strategic investment that will really change the business, the right measure really includes the prospective cost of capital, because it will change the basic shape of the company’s risk/return portfolio of investments into the future. It makes no sense to gauge it solely by a measure that doesn’t take into account what the strategic investment is designed to accomplish.
Consider a major strategic investment that promised to really change the company’s relationship with its key accounts – its islands of profit – accelerating major account profitability by increasing the value footprint and growing high-potential underpenetrated accounts. In this situation the company would have a high likelihood of actually lowering its cost of capital and a lower likelihood that the cost of capital would stay the same.
Viewed from this perspective, the proper cost of capital to use to evaluate the investment would be a blend of the current cost of capital with the prospective cost of capital – the costafter the strategic investment was made and not solely the cost in the absence of the game-changing investment. After all, if the strategic investment has the effect of reducing the cost of future investments, shouldn’t this be counted as a major benefit?
This consideration is especially relevant for major strategic investments in public companies, where investment bank analysts’ views of a company’s prospects can have a major impact on the company’s stock price and multiple.
The practical-minded retort is that it is prohibitively difficult to estimate the prospective cost of capital for every possible investment. This is true and compelling. But it certainly is possible, and indeed feasible, to estimate it for the occasional critical strategic investments that will really change the business.
Managing Big Risks
So, how do top managers actually assess major strategic investments? An important study conducted a number of years ago found that one of the most important measures actually used by top executives was the discredited measure, payback period.
Payback period is simply the number of years needed to recoup an investment. It is discredited relative to NPV and ROI because it fails to account for the time value of money: Two investments may have the same payback period, while the first generates most of the benefits right away and the second generates most benefits at the end of the interval. Clearly, the first investment is superior, even though they both look the same by the payback measure.
So why do top managers pay so much attention to payback period in evaluating major strategic investments? Because a major strategic investment by definition changes the paradigm of the business, creating new value and often provoking competitive response. Therefore it is extremely difficult, if not impossible, to gauge the costs and benefits. It also may well absorb the company’s ability to undertake major change for some time.
In this situation, a key top management question is: When will we able to make another major strategic move? Payback period provides an important insight into this critical question.
Cost of Confusion
I remember working with a major telephone company in the early days of deregulation. The company served a broad area that included a major metropolitan area with a number of global companies clustered in a few dense locations. These companies were a prime target for new emerging competitors.
As the competitors entered the city and gobbled up the telephone company’s islands of profit customers by deploying fiber and offering new services, the incumbent was hobbled and couldn’t respond. It lost block after block of its most important business.
Why? Because its traditional business case process required an explicit estimate of costs and benefits for each investment (a holdover from the days of regulation). And preventing a competitor from taking existing business – preventing the erosion of critical customers – was deemed by the finance group as not counting toward investment benefits because it was too “hard” to quantify.
Here, the erroneous use of a tactical investment evaluation process for evaluating strategic investments nearly cost the company its most lucrative business.
Profit Maps Into Action
Thoughtful assessment of investments is the key to maximizing both asset productivity and strategic success.
For tactical investments, the key is developing a hurdle rate that reflects the right cost of capital for the risk/return profiles of the respective investments. As a practical matter, try bundling the candidate investments into three groups: high risk/return, medium risk/return and low risk/return. Each group requires a different hurdle rate reflecting its different cost of capital. In this context, the traditional assessment measures, NPV and ROI, are very useful.
Strategic investments, however, are fundamentally different from tactical projects. They require a very different assessment process – one that goes beyond traditional cost/benefit analysis to reflect the strategic relevance, the prospective cost of capital and the payback period.
The strategic relevance incorporates the important hidden costs of complexity and future opportunity costs, the prospective cost of capital embraces the possibility of game-changing gains that fundamentally alter the company’s risk/return profile, and the payback period speaks to the chess-like issue of when the company will be in a position to make its next major strategic move.
In the critical process of converting a profit map into results, wisely assessing investment opportunities is critical. And getting strategic investment assessments right makes all the difference between long-run success and failure.
Jonathan Byrnes is a senior lecturer at MIT and author of the recent book, Islands of Profit in a Sea of Red Ink. He is president of Jonathan Byrnes & Co., a consulting company with which he has advised over 50 major companies, medical institutions and industry associations. Contact him at [email protected].