5 Ways to Improve Your Investment Analysis

In my own version of throw-back Thursday, I thought budgeting season (for many) would be a good time to revisit a discussion I had with Professor Aswath Damodaran reviewing the data from the 2020 AFP? PROJECT INVESTMENT AND COST OF CAPITAL SURVEY REPORT. The full report can be found here: https://bit.ly/3qWjVmn

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Aswath Damodaran is a Professor of Finance at the Stern School of Business at NYU where he currently teaches corporate finance and equity instruments and markets. He has written widely used academic and practitioner texts on Valuation, Corporate Finance and Investment Management; he has been published in leading journals of finance, such as the Journal of Financial and Quantitative Analysis, The Journal of Finance, The Journal of Financial Economics and the Review of Financial Studies.?While discussing the data from this survey, Professor Damodaran suggested several best practices for the corporate finance practitioners, summarized below.

?THE WORLD IS CHANGING; YOUR DECISIONS SHOULD AS WELL

— Once a company has taken a project, it acts like it is locked in and cannot ever revisit that decision. I think that’s a mistake.

— A project that looked good to you two years ago because it beat the hurdle rate may have now become bad and there is an action you can take, which is reduce how much money you continue to invest in it.

— Those cash flows in your original project analysis; what makes you think those numbers are set forever? Those numbers are and should be changing. We live in a world of change. To think that change doesn’t happen doesn’t make it go away.

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UPDATE YOUR COST OF CAPITAL FREQUENTLY

— People are not being dynamic enough, flexible enough to go back and revisit the numbers. We live in a world where risk and/or the price of risk can change essentially overnight and we have to reflect that in our calculations.

— Once you’ve got the capital framework nailed down, you can make it dynamic. Having a dynamic cost of capital does not take more time than having a static cost of capital. It just means a spreadsheet has inputs that are live (like the treasury bond rate and the price of risk).

— Your cost of capital should change over time to make a more reasonable assessment of where you should invest and to reassess past investments.

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CASHFLOWS OUTWEIGH THE IMPACT OF COST OF CAPITAL IN IMPORTANCE

— The amount of noise created by changing your cost of capital rate is drowned out by the amount of noise from your cash flows changing.

— I think we spent too much time coming up with hurdle rates and too little time on the cash flows. If you ended up with a messed-up project, most of the time it’s not because you’ve got the hurdle rates wrong. It’s because you’ve got the cash flows wrong.

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PLAN AGAINST OPTIMISTIC BIAS IN YOUR PROJECT CASH FLOWS

— I think you have to take project forecasting out the hands of people who would actually want the project to be taken. Create some separation between the decision makers who want to take the project, and the people that provide the numbers to make the decision on whether the project actually should be taken.

— As long as you just have a project advocate doing all the number crunching on a project, you’ve lost the game. You also need to have a counter project advocate whose job is to essentially take all of the information that a project advocates and look at all of the things that can go wrong.

— Companies think that if they tell people to be objective, they will be objective. Human beings are capable of incredible amounts of delusion. I think we need to be more open about the bias in this process and be more open about confronting it, when it is driving the numbers. What makes that process difficult is that bias often comes from the top down, with top managers often signaling their bias, and people below them scrambling to deliver numbers that back up the bias.

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DON’T ASSUME DEBT FINANCING IS CHEAPER THAN EQUITY

— In 2017, with the new tax reform act, essentially overnight the advantage of borrowing dropped by about 50 percent because a marginal tax rate in the U.S. use to be close to 40 percent and that has now dropped to about 23 or 25 percent.

— I would expect to see companies lowering debt ratios because the advantage of debt has become much smaller, but I’m not seeing companies doing it yet. That leads me to believe that many of these CFOs are buying the myth that debt is cheaper than equity and that borrowing money always lowers your cost of capital.