Saturday, September 25, 2004

Portfolio Analysis - Opportunity Evaluation (Beyond IRR and MIRR)

OK so I wrote a long screed against IRR and said that MIRR is a better metric, I consider that a fact. But does that really give the answer?

It is a good start. Given that you have some system to prioritize opportunities, you can end up with the highest value. That is usually not the whole picture though. Within a single project, there are usually distinct alternatives to consider. For example, sometimes a project may be able to trade current capital expenditure for future operational expense. This may have the impact of ultimately reducing margins, but giving the company additional leverage in the short term.

So how do you do it? There's really a continuum of methods ranging from simple standalone analysis to a more complete approach incorporating estimates of risk and uncertainty. I believe that most organizations can benefit from a portfolio analysis approach, which tends to the complete side of the spectrum.

In a perfect world, here's what that looks like. You need an inventory of your current operations at a level of decision granularity that reflects potential decision units. Depending on the industry, it could be product line, geographical area, value chain component, or even related to organizational boundaries. It is also useful to understand some of the flexibility inherent in the operations, e.g is there a scenario to increase or decrease production or divest or increase interest. Is there an investment or investment program that could have an impact on the operations? Next you need an inventory of opportunities and an understanding of the potential decisions around them. Typically the decisions are divest, delay, and accelerate.

Finally, and this is usually the hard part, a sense of the organization's financial and operational goals, metrics, and constraints. Typically, these are things like earnings increases over time, constraints on capital spend reductions in expense, etc.

It's also nice to have a quantitative estimate of the risks and uncertainties for each of the options, but that could be asking a lot of an organization.

Once you assemble the data, there are a number of approaches to take. the first step though is to establish your baseline case. Typically, this is manual. Simply select a set of mutually exclusive choices that represent where you think you are going or that contains the recommended cases from your business units. Then look to see how the data rolls together. Is it a growth pattern that seems sufficient, do the capital needs seem reasonable? If it looks fine, maybe you have your answers,

I suggest you go through another step though. Fiddle with some of your metrics. See if you could increase your earnings growth through selection of different project alternatives while maintaining the same overall level of capital and operational expenditures. Try to understand some of the tradeoffs between growth and earnings.

If you have more than 50 or so decision units or assets to consider, this is very difficult to do manually, even with computers. But modeling techniques have come a long way. Using a program like Excel with What's Best and Crystal Ball added in, or Analytica with the new optimization engine, you can explore the infinite combination of decisions quickly to understand the tradeoffs and possibilities in your business.

This can be a yearly direction setting effort, or what I would recommend is that you keep a fairly current inventory of options and as a project approaches its alternative selection time, put those options into your optimization model and see if there is a best fit with corporate goals and other options that have since been locked in.

All this sounds like a lot, but if you have formal planning and project management processes in place it is really an incremental step.

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