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University of Southern California
INNOVATION
Supplement B:
Investment Selection & Investment Merit Score
©2000, Michael A. Mische
MOR 559 – Strategic Renewal
University of Southern California
Investment Decision-Making
DESCRIPTION
KEY DECISION CRITERIA
The decision-making process involves an evaluation
of each major investment opportunity or concept for
new products, acquisitions, technologies and business
processes using multiple criteria.
The investment merit of a project
is determined based on a number
of factors, including but not
limited to:
The criteria used in the process represent a
combination of quantitative and qualitative data:
•
•
Quantitative data includes ROI, NPV and EVA
calculations, estimates as to revenues, selling
prices, earnings, cash flows, costs, gross
margins and EBIT.
Qualitative data includes assessments such as
strategic fit, competitor reactions and
positioning, product longevity, business,
technical and regulatory risk.
The weightings assigned to each criteria are
adjustable based on the type of project, its investment
requirements and priorities.
The overall investment making and project review
processes are supported by a number of activities,
including the product development process.
©2000, Michael A. Mische
•
Financial return generated
•
Market value created
•
Business, technological and
regulatory risks
•
Technology involved or
required
•
Markets created or market
share gained
•
Strategic value
•
Operational need
•
Infrastructure need
•
Patent value
MOR 559 – Strategic Renewal
University of Southern California
Decision-Making Prerequisites & Information Requirements
INVESTMENT DECISION-MAKING
The process uses an objective method for
evaluating an investment and its impact on the
overall capital portfolio of the company.
Projects are considered for investment merit
only after :
•
They have been subjected to multiplelevel review processes, screens and
filters
•
Financial returns have been calculated
•
Business plans have been completed
and reviewed
•
Executive sponsor has been assigned to
the project
•
Rigorous reviews by appropriate
operational, financial, regulatory and
business specialists have been
performed
©2000, Michael A. Mische
SOURCES OF INFORMATION
•
Financial data and ROI, NPV or
EVA are calculated by the project
sponsor and confirmed by the
SMG and the finance group
•
Strategic data, risk assessments
and technology reviews are
developed by the project
sponsors
•
A business case is completed and
linked to the product
development process, as
appropriate
•
A discussion of the investment
merits and implications of the
project
•
An assessment of the project’s
impact on the P&L
•
A comparison of financial
performance benchmarks
MOR 559 – Strategic Renewal
University of Southern California
Investment Scoring Process… Using the IMS
INVESTMENT SCORING
BENEFITS OF IMS
Investment decisions and changes to the
project portfolio and priorities are based on
a relative score that an investment earns
through its assessment process.
•
The IMS is a method that helps to reduce
subjectivity and bias from the investment
decision-making process.
•
Formal application and continuous use of
the IMS allows for evaluation and
comparison investments more
objectively.
•
Evaluating investments against one
another provides the company with the
ability to optimize its investments and redirect investments to their highest and
best uses.
•
The IMS establishes the baseline for the
project that can be reviewed and
audited against.
In general, investments (projects) that
generate a higher (or the highest) investment
merit score (IMS) will receive the greatest
level of attention and consideration.
However, there will be situations when
investments will be made, while obtaining
lower IMS ratings:
•
Physical infrastructure needs
•
Certain IT investments
•
Certain investments mandated by
regulatory, legal and other relevant
guidelines
©2000, Michael A. Mische
MOR 559 – Strategic Renewal
University of Southern California
IMS… Calculating the Investment Score
Project’s ROI,
0.5 NPV or EVA
Project’s
Strategic
Risk
X 0.3
Scale
DEFINITION
Represents the
financial contribution
of the project to
revenues, earnings
and shareholder value
DESCRIPTION
Highest weighting
factor
Based on the
financial analysis
performed on the
project
See special section
for using EVA
SOURCE
Calculated by the
project sponsor and
confirmed by finance
©2000, Michael A. Mische
X 0.2
Represents the
business and
strategic assessment
of of project and its
relative risk
Second highest
weighting factor
Based on the riskreturn relationship
Based on 10
differentiating
weighting factors
Calculated by
ELT/SMG based on a
comprehensive
assessment
Project’s
Portfolio
Effect Score
Estimates the impact
of the project on the
overall capital budget
and sources of funds
Third weighting
factors
Based on the
funding sources
and requirements
of the project
Calculated by
ELT/SMG based on a
review of portfolio
and capital plans
=
Investment
Merit Score
Represents the
project’s merit score
Considers the
overall numeric
value of the
project
Calculated/confirmed
by the IPC and
sponsor
MOR 559 – Strategic Renewal
University of Southern California
IMS… A 4-Step Calculation
STEP 1:
Calculate the project’s NPV, ROI or EVA
STEP 2:
Calculate the project’s strategic risk score
STEP 3:
Calculate the project’s portfolio effect
STEP 4:
Calculate the project’s IMS = Weigh and Total Steps 1-3
RESULT:
Once calculated, rank the project’s IMS score
against other projects.
©2000, Michael A. Mische
MOR 559 – Strategic Renewal
University of Southern California
STEP 1: Calculate the Project’s Financial Contribution
Project’s ROI,
0.5 NPV or EVA
©2000, Michael A. Mische
Project’s
X 0.3 Strategic Risk
Scale
X 0.2
Project’s
Portfolio
Effect Score
=
Investment
Merit Score
MOR 559 – Strategic Renewal
University of Southern California
Step 1… Key Questions: Financial
What is the estimated impact of the product or process on generating sales
and revenues?
What is the estimated impact of the product or process on costs?
What is the estimated impact of the product or process on profits?
To what extent are the product’s prices likely to decline?
What is the likelihood of significant price degradation over the forthcoming
5-year period?
What is the anticipated growth rate sales in terms of units and dollars?
To what extent does the product/process increase EPS?
©2000, Michael A. Mische
MOR 559 – Strategic Renewal
University of Southern California
Step 1… Calculating the Project’s Financial Score
PROCESS STEPS
GUIDELINES
STEP
DESCRIPTION
1.
1.
Calculate the project’s ROI,
NPV or EVA
For EVA, use the dollars or value
created over a given period
2.
Use NPV or ROI in favor of IRR
2.
Confirm calculation with other
responsible units/parties
3.
Calculate weighted score
©2000, Michael A. Mische
Project A
0.5 * 38% = 0.19
Project B
0.5 * 32% = 0.16
Project C
0.5 * 26% = 0.13
MOR 559 – Strategic Renewal
University of Southern California
Step 1: Calculating the Project’s ROI, NPV or EVA
VALUATION APPROACHES & CONSIDERATIONS
Often, companies use both ROI and NPV as
indicators of financial contributions and
financial viability. However, these are
traditional, internally focused measurements
that do not consider the impact of the
investment on shareholder value.
•
Subject to accounting method
manipulation
•
ROE is sensitive to leverage
•
IRR assumes that rates are continuous
•
High ROI does not correlate with
increases in market value in dollar terms
•
High ROI does not necessarily correlate
with higher EPS or PE ratios
SOME PLUSES & MINUSES
Traditional measurements are adequate for
most projects and investments:
• IT investments
• Infrastructure investments
• Some acquisitions
• Products
• IPRs
• Some R&D
In other situations, more sophisticated
valuation practices must be applied:
• Major product initiative
• Major line extension
• New processes
• Acquisition of technologies
• Company acquisitions
THE ISSUE
The key indicator for investments is not only the percentage return,
but mainly the dollars generated and market value created.
©2000, Michael A. Mische
MOR 559 – Strategic Renewal
University of Southern California
Step 1: Calculating the Project’s ROI, NPV or EVA, cont’d.
Empirical studies (Credit Suisse) indicate that EVA shows
the greatest correlation to changes in market value added
(MVA).
BENEFITS OF EVA
•
EVA = (ROC - COC) (CI)
Where:
ROC is the “true” cash flow return on capital
earned on the investment, or:
CI is the amount of capital invested in the project.
©2000, Michael A. Mische
•
Based upon objective data that is
not easily manipulated
•
The value of a firm, in DCF terms, can be
written in terms of the EVA of projects in
place and the present value of the EVA
of future projects.
•
EVA is the best single-period measure of
realized value creation; EVA ties directly
to the governing objective of
shareholder value creation.
MVE… market value of equity
Tot. Cap… sum of total equity and total debt
Simple and easy to understand
EVA is the closest in both theory and
construct to the NPV of a project in
capital budgeting, as opposed to the
IRR.
COE… cost of equity
TVD… total value of debt
•
•
Used to finance the project, or:
COD… cost of debt
Directly linked to shareholder value
EVA is a measure of dollar surplus value,
not the percentage difference in returns.
COC is the weighted cost of capital
COC = COE (MVE/Tot. Cap.) + COD (TVD/Tot.
Cap.)
•
•
ROC = (NOPAT)/(BV of Equity + BV of Debt)
NOPAT is not operating profit after taxes
EVA has some desirable attributes:
MOR 559 – Strategic Renewal
University of Southern California
STEP 2: Calculate the Project’s Strategic Risk Score
Project’s ROI,
0.5 NPV or EVA
©2000, Michael A. Mische
Project’s
X 0.3 Strategic Risk
Scale
X 0.2
Project’s
Portfolio
Effect Score
=
Investment
Merit Score
MOR 559 – Strategic Renewal
University of Southern California
Step 2… Key Questions: Strategic Risk
REGULATORY/LEGAL/OTHER:
To what extent does the product require significant regulatory, legal or other compliance, review and
testing?
What are the estimated levels of such efforts?
TECHNOLOGY:
To what extent does this technology displace existing technology?
To what extent does the company currently possess the technology necessary to manufacture this
product?
To what extent does the proposed concept or product provide an existing platform?
To what extent does the company possess the adequate skills and competencies to manufacture and
service the product/process?
What is the overall level of risk of the technology as related to emerging technologies and their
potential for obsolescence?
To what extent is the current environment favorable to the concept, design and operation of the
product?
MARKET:
At what rate are the markets growing?
To what extent are the markets driven by, or sensitive to, changes in the reimbursement processes?
To what extent does this product demonstrate or provide cost savings relative to the best
product/price in the market?
To what degree can the product be sold into or across multiple areas and market segments?
To what extent does this product/process change the dynamics of the marketplace?
What is the potential that the product/process infringes upon the patent or intellectual property rights
of another company?
©2000, Michael A. Mische
MOR 559 – Strategic Renewal
University of Southern California
Step 2… Calculating the Project’s Strategic Score
PROCESS
GUIDELINES
STEP
DESCRIPTION
1.
Determine the project’s risk level (market, R&D,
regulatory, economic, other) on a scale of 0-10
Assign a corresponding weighting to each risk
category (on a scale 0.-2.0)
Determine the reward level (strategic
offensive/defensive, key technology, market
access, other) on a scale of 0-10
Assign a corresponding weighting to each reward
category (on a scale 0.-2.0)
2.
3.
4.
©2000, Michael A. Mische
Project A
0.3 * 0.8 = 0.24
Project B
0.3 * 1.5 = 0.45
Project C
0.5 * 1.2 = 0.36
1.
Use a developed
Project Investment
template
2.
Use the the
calculated
risk/reward ratio as
an input for
Strategic Score
MOR 559 – Strategic Renewal
University of Southern California
STEP 3: Calculate the Project’s Effect on the Portfolio
Project’s ROI,
0.5 NPV or EVA
©2000, Michael A. Mische
Project’s
X 0.3 Strategic Risk
Scale
X 0.2
Project’s
Portfolio
Effect Score
=
Investment
Merit Score
MOR 559 – Strategic Renewal
University of Southern California
Step 3: Calculating the Project’s Effect on the Portfolio
KEY QUESTIONS
Do the existing budget or any available funds support this project?
If funds do not exist, where will they come from:
Self-funding
Shifting priorities
Changing budgets of existing projects
To what extent will this project improve overall portfolio performance?
How will this project impact the overall aging of the portfolio?
©2000, Michael A. Mische
MOR 559 – Strategic Renewal