Owners and CEOs of middle market and smaller privately owned companies have to make cash investments in the future of their companies just like the Fortune 1000 do. But they often don’t have the seasoned financial analyst on board to develop discounted cash flow calculations, and when they do it’s often challenging to understand the process, to estimate (and trust) the future cost of money and interest rates projections, etc. Often the result is a decision made by gut feel – sometimes a good result and sometimes not so good. There ought to be an easier way.
Actually there is. It’s a different but useful way of assessing investment value. Rather than doing a present value calculations with all the elements that might impact that ROI arithmetic, consider a much simpler approach that has the value of being both logical and instantly understandable – Payback Period.
In this approach, analysts can pull together information that their people are most knowledgeable about: what the investment will cost and what they believe it will produce in value over time. You pay money out, you earn money as a result of the investment, and when the money earned has equaled the amount paid out, you’ve been paid back for that investment, and all future returns are profits. If the timeframe it takes to get to that point is reasonable, you make the investment, e.g. a 2-3 year payback period might be excellent, while a 20-year payback period might mean it’s a non-starter. At that point it becomes a management decision, but a reasonably well informed one.
Of course, if you don’t have credible information about the expected returns from making an investment, there’s a serious question to ask: should you even be considering it? An investment made to have the next shiny thing in your building – or the latest version of whatever – isn’t really an investment at all, it’s a personal ego satisfier. Nothing wrong with that if you have the money, but then there’s little value in trying to justify it in financial terms. Investments should be made to build enterprise value, and enterprise value comes from increased profitability, increased productivity (followed by increased profitability), increased efficiency (followed by increased profitability), increased market share (followed by increased profitability), etc.
If that’s not clear, call us. We are Your CFO for Rent.