Financials Valuing an Investment

When reviewing your budget, a key factor to consider is whether the valuation of the investment makes it valuable to the company. It's important to assess whether the amount of money being allocated makes sense. Often, you will need to evaluate different recommendations and compare their relative value before making a decision. This evaluation should involve both quantitative and qualitative factors. Tools such as Return on Investment (ROI), Net Present Value (NPV), and Internal Rate of Return (IRR) are typically used in this process

To calculate ROI, determine the profit or loss generated from the investment. This is done by subtracting the cost of the investment from the return and then dividing the result by the cost. A positive percentage indicates that the investment is profitable, while a negative percentage suggests potential losses. Remember that ROI is expressed as a percentage and can be calculated on an annual basis or as a cumulative figure. It’s a straightforward method that many teams often use early in the evaluation process due to its simplicity.

NPV and IRR are more complex calculations. For NPV, you need to discount future revenues and cash flows. If the result is positive, it indicates that the investment adds value to the company; if negative, it detracts from the company's value. NPV is based on a discount rate, which reflects the project's risk and helps determine the cost of raising new capital. The goal is to have a positive NPV.

The IRR can actually be calculated before the NPV, providing insight into what discount rate will result in an NPV of zero. Ideally, you want the future cash flows to be valued higher in today’s dollars, as indicated by the NPV. In cases where NPV and IRR provide conflicting results, prioritise NPV for your decision-making process.

Additionally, consider conducting a sensitivity analysis and scenario analysis to evaluate the investment under various conditions. You can define scenarios such as worst-case (0% growth), base case (2% growth), and best case (4% growth) to understand the potential variability in outcomes. By plotting these scenarios on a chart, you can visualise the implications of each scenario as you move forward with your evaluation.