Category: Planning

What DOES That Logo Mean?

Our first logo is the mathematical formula for calculating the Net Present Value of Cash Flows (CF), using a discount rate of 10%, or as often called in industry, “npv10.”

The symbol Σ means to sum all the values in the series represented on the right.  Although I don’t include the bounds, they are often assumed to be from time period zero (initial investment) through some future time period.  CFt thus representing the cash flows for time period t.

The divisor is 1.1t, while the general formula should be divided by (1+i)t. As I named the company npv10, I just assumed the interest rate i was 10% or 0.1. For time period zero the divisor is 1.10 (equals 1), for time period 1 it is 1.11 (equals 1.1), and so forth.

But why the NPV of Cash Flows?  Why not NPV of Net Income or Revenues or EBITDA, or use IRR (Internal Rate of Return)?

The NPV of Cash Flows has been found to be a good way to compare projects to one another, and take into account the timing of the cash flows to the company.  Earning money back sooner is more valuable to earning the same amount later.

But the software does not compare projects against one another according to their individual NPV.  A number of successful companies do that, but they’re missing out on a number of important points:

  • Projects do not exist in isolation.  They compete for limited resources with other opportunities, so they are all interrelated even if not obviously so.  (See the example I did for a technology company.)
  • Projects may directly depend on other projects.  For example, an oil company may drill a test well, and the result of that test may determine how many other producing wells they drill in the area.  The test well is not expected to produce any return, so it has a negative NPV.  But if the test is positive, each of the production wells can move forward, producing positive returns.  Our software enables you to directly connect one or more projects, so selecting one or more producing wells (with positive NPV) requires that the associated test well (with negative NPV) is also selected.
  • Timing matters.  If you are attempting to manage the company, and it selects nothing but projects with large NPVs, where the positive cash flows are in the distant future, you will need cash to sustain you until those start returning cash.  This is why I often recommend setting minimum goals for Cash balances, to ensure the company survives any periods of low cash flow.  In this way, the software may select projects with smaller NPVs first, because they may return cash sooner, and that can be put back into funding the larger projects later.

The final point I wish to make is that while I named the company after a useful calculation, the software allows you to set goals and constraints on almost any of your metrics and KPIs, and decide which one you wish to maximize or minimize for each analysis.  You may wish to maximize Revenue, Production, or Revenue, or minimize Capital Expenditures, or Marketing Expenses, to see how you can best achieve your strategy.

As your company figures out which goals, constraints, and optimized metrics most matter, you will get the most value for your company, and help it develop its strategy and plan for the future.

What is it worth to YOU?

Going into a negotiation, the management team of a mid-sized company discussed a potential deal:

Business Development: If we can buy it for $68mm or less, it clears our hurdle rate.
Chief Strategy Officer: What’s our BATNA? [Best Alternative To a Negotiated Agreement]
Senior FP&A Analyst: If we pay $68mm, it reduces our enterprise value. We have to get it below $54mm to be a net positive.
Chief Strategy Officer: Why is that?
Senior FP&A Analyst: Paying any more than $54mm and using other resources on this project keeps us from doing a few other projects that are collectively worth more to us than this one.

This conversation happens all the time at companies that actively use portfolio management to aid their decision making.

Two or more companies could use the exact same forecasts and assumptions about an acquisition, but may still decide it is worth different amounts. That’s because the companies all have different alternatives. If they complete the acquisition, it will likely mean they cannot do other projects under consideration. And that’s because few companies have infinite resources, and doing Project A means you may not be able to move forward with Projects B and C.

The value of the npv10 solution is to very quickly evaluate your alternatives, recalculate all of the pertinent key performance indicators, all while achieving corporate goals within the given constraints.

Beyond the quick analysis, executive discussions can focus on relaxing constraints (perhaps by raising additional capital, or finding other necessary resources) to enable the firm to take on additional valuable projects. The software will show which KPIs are “bumping against the ceiling” and you can decide if they are “hard ceilings” or have some flexibility.

If you are frequently considering acquisitions or divestitures, and want to quickly determine how they impact your company, let us help model your business and its opportunities, and show you how to maximize your company’s value.

Strategic vs. Opportunistic

“What’s the difference between being strategic versus opportunistic?” a friend recently asked.

After thinking about it, I answered, “Suppose you want to make $1,000. Being strategic means you come up with a strategy or plan that you reasonably expect to make that amount, perhaps investing in a stock or bond, or take a job that pays that much. Being opportunistic means you wander the streets looking for loose change.”

It is usually straightforward to know how a company operates by looking at its portfolio of business lines. Strategic companies have fairly similar-looking opportunities, almost cookie-cutter in their appearance. By knowing what they do well, they develop plans to replicate their successful endeavors. Having this tight focus enables them to have better insights into how these ventures work, and hopefully work together for greater efficiencies.

Opportunistic companies are always on the lookout for “a good deal.” Their portfolio is a collection of seemingly unrelated ventures, with little or no cross-venture benefits. They may still make a good deal of money, but they are dependent upon a sufficient number of acceptable deals to come their way. In essence, they wait for opportunities to come to them, instead of making the opportunities happen.

If we look at the world’s largest companies, we see 14 banks in the top 50, 6 oil companies, 6 automotive companies, 6 insurance companies, 5 utility-like companies, 3 drug companies, 3 tech companies, 2 consumer electronics companies, and 2 consumer packaged goods (CPG) companies. There is only one potentially opportunistic company among the 50, Berkshire Hathaway, although they may actually be an insurance company that also invests opportunistically in a wide variety of industries.

These are the most valuable companies in the world, and they show the value of a focused strategy. They didn’t become that valuable waiting for opportunities to come along. They made the opportunities happen.

Using a disciplined portfolio strategy will enable you to set audacious goals and develop a plan to achieve them. Contact us to start you on the path to becoming one of the LARGEST COMPANIES in your industry.