How ROI Models and Benchmarks
Improve Strategic Capital Allocation
The path to truly strategic capital allocation can be littered with obstacles — insufficient data, disjointed workflows, departmental silos, a “spend vs. invest” mindset and biases among them.
One way to overcome hurdles like those is to leverage the power of objective, data-driven models and benchmarks. In this piece, we’ll delve into how companies can use consistent, well-constructed models to gain valuable insight into the potential of projects – both individual and in portfolios – and ensure that every investment aligns with the company’s overarching objectives.
Unlock top-level performance with dynamic reallocation
As stated in our first piece in this series, top-performing companies consistently prioritize long-term value by strategically allocating, and re-allocating, capital in response to evolving conditions, emerging opportunities or changing growth potential of specific business units.
Unfortunately, many companies underperform their peers – and it starts right at the beginning of the capital allocation process. That’s because they base their capital budget, and the projects it will support, on the prior year’s spend. To use an analogy, they forecast clear skies tomorrow because it’s sunny today. This approach lacks flexibility and often leads to suboptimal returns, primarily because it doesn’t prioritize the highest ROI projects or investments that have longer-term potential.
Moreover, this “static” approach to capital allocation turns a blind eye to the inevitable variances a business faces with regularity – whether it’s tied to macroeconomics, leadership changes, business unit performance, or the like. A more “activist” or dynamic approach can change all that.
Researchers at the University of Sydney, for example, after examining a wide range of firms over a ten-year period, concluded that “reallocation processes are a necessary condition to make the right investments over time.” They looked at the relationship between two variables—deviation of investment ratio (DIR), which represented the dynamism of a firm’s capital reallocation, and return on assets (ROA).
A DIR increase of just one standard deviation was correlated with “an industry-adjusted ROA increase of 0.29 percentage points. For the average Fortune 500 company with assets of $80 billion, this former figure extrapolates to a gain of $232 million per year.” Ultimately, the researchers concluded that “for the vast majority of firms, the model predicts that greater reallocation is correlated with higher performance.”
The research is clear: dynamic capital allocation is consistently shown as a marker of top-level returns, and one of the “engines” of this is quality ROI models. Whether you’re new to evaluating models, or could just use a refresher, here’s a primer on the most common ROI metric\ and their pros and cons.
Understanding different ROI metrics for capital planning
Net Present Value (NPV)
A widely-recognized discounted cash flow metric, NPV is the difference between the present values of future cash inflows and outflows. It represents the net value or profit in today’s terms. A positive NPV suggests a promising investment, whereas a negative one indicates potential loss.
Formula: NPV = Present Value of Future Cash Flows – Initial Investment
Internal Rate of Return (IRR)
IRR offers a percentage-based return, making it easy for managers to compare projects to their company’s cost of capital. However, IRR can sometimes be misleading due to its potential for multiple values for certain cash flows, especially when comparing mutually exclusive projects.
Formula: This one is a bit more complex; you can review it here.
Profitability Index (PI)
PI measures the value generated per investment by comparing the present value of future cash inflows to the initial investment. A PI above 1 suggests a favorable investment, while below 1 indicates the opposite.
Formula: PI = Present Value of Future Cash Flows / Initial Investment
Hurdle rate represents a company-specific minimum return for potential projects. While not an ROI metric per se, it’s closely linked to ROI evaluations. Typically derived from the company’s weighted average cost of capital (WACC), it can be adjusted based on project risk. Most companies use a hurdle rate, whether explicitly or implicitly, in investment evaluations.
Of these metrics, NPV and PI are typically considered the most useful. Here’s how to choose between them.
NPV versus PI
Both metrics offer unique insights, but their viability varies based on the context and objectives of decision-makers. Here’s a breakdown of the factors to consider when choosing between NPV and PI:
- Decision-making clarity – PI is a relative measure which simplifies the comparison of multiple projects. In contrast, NPV delivers an absolute value, which could be preferred when the focus is on the total value a capital project can create.
- Scale sensitivity – PI has a tendency to favor smaller projects that have a higher return ratio, even if the absolute value added is minimal. On the other hand, NPV tends to lean towards projects that contribute the most total value, potentially favoring larger initiatives.
- Project prioritization – PI excels when ranking projects with limited capital. NPV, in contrast, offers insights into the net value a project brings.
- Budget constraints and long-term strategic planning – PI is effective under stringent budget constraints, but it might sideline long-term strategic projects in favor of short-term efficiency gains. NPV can inadvertently sideline smaller, efficient projects in pursuit of larger, high-value ones.
PI: The superior choice for capital planning
From our perspective, and that of experts, PI is superior to NPV for capital planning. Here’s why:
A relative measure for enhanced decision-making
According to researchers at Iowa State, by providing a relative measure of the value created per unit of investment, PI “is useful for comparing two or more projects which have very different magnitudes of cash ﬂows.” In contrast, NPV delivers an absolute value, which may not always provide the clarity needed for prioritizing projects.
Efficiency in capital rationing
PI is particularly effective “in situations where two, mutually exclusive, projects deliver the same amount of money in terms of NPV, but one project costs twice as much as another. This is when the profitability index (PI) gives the best answer.”
Measure your portfolio as if it were a single project
PI stands out as the optimal ROI metric for an entire investment portfolio. By adding up the cash flows from each project, you can calculate a PI for your entire portfolio as if it were a single project. Within Finario, for example, you can compare a range of portfolio scenarios within a specific year or across multiple years.
Many companies will, of course, take a hybrid approach – using two or more modeling approaches to gain the most clarity. Regardless of which models are deployed, however, here are some best practices to consider.
ROI modeling best practices
Consistent application across the enterprise
It’s essential to ensure that ROI models are constructed and applied uniformly throughout the organization. Such consistency ensures that all projects, irrespective of their scale or department, are evaluated on the same grounds, leading to objective and comparable results. Unfortunately, this is quite difficult to achieve when an organization is still relying on spreadsheets — as there is less centralized oversight, and data can be poorly synchronized. With a purpose-built solution such as Finario, however, it’s always consistent and accurate.
Available when capital allocation decisions be being made upfront
While checking that the return from a Capex request exceeds a minimum hurdle rate before granting final approval is a sound practice, it’s really too late for that ROI analysis to be useful for strategic capital allocation. And a budgeting process that doesn’t incorporate ROI metrics for material projects, well that isn’t sound capital allocation at all. The real utility of ROI modeling is to inform long term asset planning strategy and an annual capital budgeting process that takes appropriate measures of financial return on material projects. Sound strategy and allocation, of course, then rest in turn on sound ROI modeling and project level ROI metrics.
Pairing with risk assessment
Every investment carries inherent risks. It’s vital to complement ROI models with risk assessment analysis and metrics and adjust accordingly. This helps to counterbalance unbridled enthusiasm and make more objective choices.
Even when we’re aware of them, biases have a knack for seeping into capital allocation decisions. McKinsey asserts that “One of the most powerful techniques for debiasing process-based decision-making are statistical decision systems,” but these models need to be monitored regularly. “Even well-constructed algorithms, when deployed on data sets full of biased observations and outcomes, can propagate and systematize biases.”
Combating “corporate socialism”
Giving each division their “fair share” of a Capex budget is a common misstep by senior leaders, who instead should be unsentimental and pragmatic in allocating capital to the highest risk-adjusted ROI projects.
Researchers at the National Bureau of Economic Research, for example, examined resource allocation within large conglomerates, and found that “the manager of the conglomerate has preferences for corporate socialism, where the headquarters gain some utility from minimizing the diversity in profits among divisions…Managers allocate too little capital to the strong division: an average two division conglomerate behaves as though the stronger division’s productivity is 9 percentage points lower than it actually is. Conversely, managers allocate too much capital to the weaker division, treating it as though it is 12 percentage points more productive than it really is.”
In the end, this phenomenon leads to slower growth, reduced profitability and suboptimal stock market performance.
Fostering a culture of continuous learning
For every material project, the ROI measurement process should be able to compare actual performance to forecasts, such as post-completion reviews. This facilitates a process of continual learning and improvement, ensuring that lessons from past projects are able to be applied in the future.
Putting ROI models to work for “capital activism”
As Newton’s First Law states, an object in motion tends to stay in motion until acted on by an external force. Becoming a “capital activist” means being that force that breaks up the inertia — challenging everyone in the organization to become more involved in seeking out and selecting the project opportunities that truly offer the greatest contribution to the enterprise’s future success.
Gartner defines capital activism as “actively directing capital flows to respond to changes in the drivers of enterprise value realization.” Doing so requires two key steps: viewing the overall capital portfolio “as a set of trade-offs and synergies,” and “applying a ‘nothing is sacred’ mindset to investment options.”
In the same report, Gartner states that responsiveness in resource allocation is key. This is defined as the ability to quickly shift resources to new high-value uses, swiftly move resources away from newly low-value uses, and make significant rather than incremental changes to resourcing when required.
This approach requires a dynamic mindset and willingness to adapt to changing conditions. The report showed that only 31% of CFOs report being able to quickly shift capital to newly high-value uses and promptly shift capital away from newly low-value uses. Even fewer, only 17%, report being able to make significant rather than incremental changes to resourcing.
Ultimately, capital activism hinges on dynamic reallocation, which is much more effective with the help of well-constructed and consistent ROI models.
Robust ROI models and benchmarks are a strategic imperative
Finario bridges this gap by ensuring that ROI models are rooted in robust, accurate data. Our platform captures the entirety of relevant project details, ensuring that every investment decision aligns with the broader organizational vision. By democratizing this data, we empower all stakeholders to make informed, strategic choices.
In the end, it’s not just about investing capital, but investing it wisely and strategically. It starts with a mindset, leadership vision, organizational commitment, and the right tools that are necessary to win in the modern “battlefield” of business.