What are the key portfolio financials for selecting the right projects?
A company is expected to increase its value, over time. It does so by growing with returns that are above its cost of capital.
A company can be seen as a selection of projects – a project portfolio. Its valuation is based on expectations of future cash flows. Generated by both existing businesses (“old projects”) and future businesses (“new projects”). (A company, especially if smaller, may replace the word businesses with Operations, or Business As Usual, BAU for short).
Ideally, a project (or rather its business case) should always have a positive Net Present Value (NPV). This is the sum of the present discounted values of incoming and outgoing cash flows over a period of time, say three to five years.
In practice, it is not possible to select projects producing positive returns only. Some projects have to be undertaken even if they have a negative NPV. For example, cyber security, regulation compliance or change/ transformation. Before accepting this, the management should ensure that for each project:
- An attempt is made to quantify the benefits in dollar terms
- The story is compelling for owners/ providers of funds and aligns with the company strategy
- All the beneficiaries are included in the business case
In some cases, it may be possible to associate risk mitigation/ infrastructure projects with revenue-generating ones. Grouping them into a ‘programme’, with a combined business case. If it is not possible, then they should at least reduce the overall riskiness of the portfolio.
Furthermore, it is not possible to ensure that every project is successful. Some projects fail for a variety of reasons and have to be written off as sunk costs. (However, good project management practices for selecting and managing projects increase the probability of individual project success.)
While each project may not produce a positive return, the portfolio must produce a positive one. And it has to do so above the cost of capital of the company.
The riskiness of operations – and projects – determines the cost of capital of the company. To avoid over-investing in risky projects and under-investing in safer ones, a different ‘discount rate’ should be used for each project. According to its riskiness. The composition of the portfolio should depend on the company/ business strategy, owners/ funders expectations, and management assumptions.
If the managers formulate the right company strategy and select strategy aligned projects, which together offer risk-adjusted portfolio returns matching owners/ funders expectations, then a fair company valuation should follow (under normal market circumstances).
To learn more about projects and value, please read the previous post.