Tuesday, November 22, 2011

Reverse Engineering NPV – Part One

When we hear the term “financial engineering” a lot of us think of a bunch of quants creating exotic market securities based on statistical features. A lot of complex derivatives are based on financial engineering (whether they should be or not!). The mortgage component of the financial crisis of 2008 was partially due to financial engineering of mortgage securities.
In this post we are going to “reverse” engineer, and our subject is a whole lot simpler than the esoteric securities that maybe...just maybe...5 people in the whole world understand.

As we have discussed in prior Treasury Café posts, the NPV methodology is the superior valuation metric. For corroboration, check out Silber, or Harvey, or Brealey and Myers. NPV stands for Net Present Value.
Because of this, when considering potential investments, we would like to know the NPV of these investments.
When evaluating the strategic options of the organization, we would like to determine which ones generate the greatest NPV.
When forecasting the organizations performance over the next year or two, we would like to know if this creates value.

What Does It Take to Get a Number Around Here?
In its original form, the NPV requires 3 inputs – length of time, cash inflows less outflows, and rate of return.
The most complicated of these to determine is usually cash.
For this reason, organizations spend a lot of time focusing on the inputs to this.
But this can get to the point of the ridiculous. In my own organizational life, after participating in a meeting that used six man hours of resources to discuss office supplies, my euphemism for this was “forecasting paperclips”.
Guy Kawasaki talks about business plans being presented to venture capitalists with a line item for pencils.
What motivates going to this level of detail is the desire to get it right. And it is important that this happen, otherwise we can wake up tomorrow to find ourselves out of business. So it is important.
Help From High School
I am convinced that some of this time and effort is spent because the NPV equation is not intuitive, it is something of a “black-box”. Division by factors with exponents and decimals is tough to do in one’s head, so we cannot immediately validate results.
Therefore, to compensate for this uncertainty, we make really darn sure we understand the numbers going into it.
However, by dint of a little algebra, the NPV equation can be re-written to solve for the EBITDA requirements of a project rather than the NPV, keeping other factors constant. It looks a little messier, but it is nothing a spreadsheet can’t handle, and we are already relying on the spreadsheet anyway, so we are not doing anything strange, different, or time-consuming.

Asking Different Questions
This perspective of the NPV equation can save us incredible amounts of time when going through strategic planning, capital budgeting, growth-funding scenario analysis, and similar activities.
This occurs because we will be viewing and evaluating the organization’s possibilities through a different lens. And this lens is EBITDA (this is an acronym for Earnings Before Interest, Taxes, Depreciation and Amortization).
EBITDA is what operating units of an organization are primarily responsible for. It is a measure before any fancy financing done by the treasury folks, esoteric depreciation brought by the accounting folks, or anomalies courtesy of our expert tax department’s knowledge.
Ask them what their EBITDA will be, and their lightening quick answer will be full of rich detail, intimate knowledge, and knowing confidence.
We will go through a detailed example in our next post!

Key Takeaways
By changing perspective:
·         Difficult answers become easy
·         Tedious tasks are replaced with productive ones
·         The focus is on things that matter
Can you share with us a time when changing your perspective made a great difference?

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  1. David, you are so right about "forecasting paperclips." Been there, done that, hopefully learned my lesson that time is previous and the focus needs to be on the big things...like NPV!

  2. Lee,

    It is likely that many of us have been there and done that more than we would have liked!

    My feeling is that focusing on the big picture, like you say, helps everything to fall into place.

    Thank you for furthering the discussion and sharing your experience!