No sensible decision can be made any longer without taking into account not only the world as it is, but the world as it will be.
Previously, we talked to you about the investment project financial model, focusing on some critical factors. This is a key factor in your strategy and your business plan. Now we will focus on the next step, which is the project evaluation, from a financial point of view, which is also one of the services we offer you.
What is project evaluation?
Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted.
First of all, we will start with a definition, since it is easy to cause confusion with subsequent instances of control and evaluation at the time of executing the project closure.
At this time, we will talk about project evaluation, performed on planning to determine if the project is feasible or not. In simple words, it is the analysis of the project to determine if it is done or scrapped.
The feasibility of a project must be evaluated from different points of view. Basically, every aspect of the Business Plan must be evaluated. In this way, you will have to carry out the technical, environmental, social, commercial evaluation, etc. Now we will focus on the financial evaluation of the project.
The financial feasibility assessment of the project will tell you if a project will contribute to the objectives of the company or will be a waste of resources. If the project is feasible, you can continue, otherwise:
- You can review it, make adjustments and re-evaluate it, or
- Discard it and focus your efforts on another project.
There are several methods for conducting the financial evaluation of projects. For the analysis of the project financial model, quantitative and qualitative methods are applied.
Number rules the universe.
Quantitative analysis, according to Investopedia, “is a technique that uses mathematical and statistical modeling, measurement, and research to understand behavior. Quantitative analysts represent a given reality in terms of a numerical value. Quantitative analysis is applied to the measurement, performance evaluation, valuation of a financial instrument, and predicting real-world events such as changes in a country’s gross domestic product (GDP)”.
In simple words, it is the analysis of the financial data of your project through numerical methods: mathematics and statistics.
Soon we will talk about some quantitative analysis methods for investment projects. This time we will focus on an element that affects the entire financial model and its subsequent analysis:
Expected Return or Discount Rate
An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.
The discount rate or return is not an evaluation method per se, however it is critical for what is to come. This rate is often referred to as the opportunity cost, which is the return on the second best investment to consider. As you can imagine, it is a matter that easily falls into the ambiguity. We will distinguish:
- When you are an entrepreneur, it is not very easy to determine the value of the discount rate. There is literature that recommends using the deposit rate of a bank or the average of the stock market; But if you are evaluating your startup, it would hardly be comparable to the meager returns on term deposits and if you have come this far, it means that your efforts are not aimed at investing in the stock market. So what rate to use? We recommend researching and determining a rate of return that can be business or market comparative in relation to your project.
- If the evaluation of the project or investment will be done within an existing company, as part of an expansion of infrastructure, products or markets, what is recommended is to use the rate called WACC (weighted average cost of capital) which is the rate of return of each component of the company’s capital, considering its relative weight within the liability structure. That is, the rates of return required by shareholders (equity) and the interest rates required in contracts with creditors (debt).
Now, once you have determined the investment rate of return or discount rate, you will have to analyze whether it is very optimistic or not. We do not advise you to use very optimistic rates, even if your idea to evaluate is unique. Remember how simple it can be to get affected by overconfidence.
It is not my place in society that makes me well off, but my judgements.
Qualitative analysis, in general, as indicated by Investopedia, is one that “uses subjective judgment to analyze a company’s value or prospects based on non-quantifiable information, such as management expertise, industry cycles, strength of research and development”
That is, qualitative analysis does not focus on calculating indicators about the project or investment, but goes further and reviews them from the subjective context.
The quantitative analysis of the financial model of the project focuses on the opinion of experts, the review by technical committees, a Steering Committee, the policy or philosophy of the company, how well it is supported, the narrative, etc.
Some of the quantitative analysis methods for investment projects are NPV, IRR, Benefit / Cost Ratio, etc. You can read more about quantitative analysis in the following article.
What method to use for project evaluation?
It has been my experience that competency in mathematics, both in numerical manipulations and in understanding its conceptual foundations, enhances a person’s ability to handle the more ambiguous and qualitative relationships that dominate our day-to-day financial decision-making.
What type of analysis to use? Which one is better than the other? It has been the subject of debate for years, without an agreement on the matter. There are no golden rules in this. However, as Investopedia points out: “Qualitative analysis contrasts with quantitative analysis, which focuses on numbers found in reports such as balance sheets. The two techniques, however, will often be used together to examine a company’s operations and evaluate its potential as an investment opportunity“.
In previous articles we have pointed out some phenomena that affect our decisions and how, sometimes, we act more from an irrational point of view than a rational one. To paraphrase Richard Thaler, we are more Humans than Economists in the decision-making process.
What is our position? When evaluating a project, we must incorporate both quantitative and qualitative analysis.
Do you need help to carry out the financial evaluation of your project? Contact us, we will take care of it.
Soon we will indicate the main methods, quantitative and qualitative, for the financial evaluation of projects.
We are Steering Bird, online advisers in business direction, management and finance. We specialize in business analysis, control and analysis of investment projects, results analysis, processes of budget and forecast, etc.