Investments are an excellent way to achieve growth and profitability for a business, but we must keep in mind that every investment carries an associated risk. Before making any decision, it is essential to analyse the investments we plan to make to assess their value.
Initially, we must determine the purpose of the projected investment and its expected outcome. The first step is to consider what type of investment we will undertake:
- Strategic: Related to the overall objectives of the company. Typically made to increase market presence.
- Growth: Invested to increase sales levels by producing new products or services.
- Replacement: Acquiring new assets to enhance production efficiency and reduce costs, as well as to replace obsolete assets.
- Compliance with administrative regulations: Obligations that require making a business investment.
Valuing a business investment is an essential process that allows companies to make informed decisions about where and how to allocate their resources.
This process involves using various financial techniques and methods to determine the actual value of a potential investment. Below, we summarize some of the most common and effective methods for valuing a business investment.
- Net Present Value (NPV): One of the most widely used methods for valuing investments. This method involves discounting the expected future cash flows from an investment to their present value using an appropriate discount rate.
- Internal Rate of Return (IRR): The discount rate that makes the NPV of an investment equal to zero. In other words, it is the expected rate of return on an investment.
- Payback Period: Measures the time required to recover the initial investment through the cash flows generated by the investment. This method is simple and easy to understand, but does not consider the time value of money or cash flows occurring after the payback period.
- Return on Investment (ROI): A measure of the profitability of an investment. It is calculated by dividing the net profit from the investment by its cost and expressed as a percentage.
- Discounted ROI: Similar to ROI, but considers the time value of money. This method discounts future cash flows to their present value before calculating ROI.
- Sensitivity Analysis: Assesses how changes in key variables affect the outcome of an investment. This method helps identify factors that have the greatest impact on investment profitability and evaluate associated risks.
- Scenario Analysis: Involves evaluating the performance of an investment under different conditions or scenarios. For example, optimistic, pessimistic, and most likely scenarios can be considered to assess how various situations impact investment profitability.
- Valuation by Multiples: A comparative method that uses financial ratios from similar companies to value an investment. Some common multiples include price-to-earnings (P/E), enterprise value/EBITDA (EV/EBITDA), and price/sales (P/S).
Valuing a business investment is a complex process that requires using multiple methods and techniques to obtain a comprehensive and accurate view of potential profitability. Each method has its advantages and limitations, so it is important to use a combination of them to make informed decisions. By understanding and applying these methods, businesses can maximize their resources and make strategic decisions that drive their growth and long-term success.
