Successful business development often requires an entrepreneur to be able to attract investment. He can do this by using a variety of tools. But in many cases, the investor’s decision on whether or not to invest in a particular business will be based on an independent analysis and assessment of the prospects of a particular project. What criteria can be used in this case?
Simplicity and complexity
Evaluation of investment projects, according to many experts, on the one hand, is associated with the multifactorial nature of the study of business ideas. Moreover, not only the properties of the concept itself can be taken into account, but also external factors — the state of the market, political processes, etc. The attractiveness of an investment project can be analyzed from the point of view of the entrepreneur’s personality and the level of sophistication of the financial plan. On the other hand, the whole essence of the corresponding study, as a rule, comes down to answering a set of simple questions: will the project be profitable, how much, and when to expect income?
Universal criteria that would make it possible to unambiguously determine which particular analysis factors most clearly affect the future profitability of a business initiative have not yet been invented even among professional investors. However, the tools with which a qualitative assessment and analysis of investment projects can be carried out in a wide range of specific solutions are quite accessible. What are the criteria by which modern investors evaluate the prospects of business ideas?
Key criteria
First of all, these are indicators reflecting the economic efficiency of investments. In the “formula” applicable to the calculation of specific numbers by this criterion, there are two basic “variables” - the investment itself, as well as the annual profit (sometimes expressed in profitability, that is, in percent). In some cases, the evaluation criteria for investment projects in this "formula" are supplemented by such an aspect as the payback period. That is, if we talk, for example, about the first year of doing business, then the investor may want to know how many months the project will at least go to zero. In general, we can say that the methodology for evaluating investment projects is tied to a time factor. The set of the most important criteria from an economic point of view is analyzed in relation to specific periods.
If we consider the criteria for evaluating investment projects that are tied to time in more detail, we can distinguish their following list:
- net present value;
- internal and modified rates of return;
- average rate, as well as profitability index.
What is the advantage of these criteria? In almost all cases, the investor receives some kind of rational digital indicator, which may allow to save several potential projects.
Optimal business model
The investor will try to calculate the "variables" in relation to the "formula" that we gave above, or similar to it, analyzing, first of all, the business model proposed by the entrepreneur. That is, to study it for the availability of solutions that are able to provide the desired revenue stream in the period that suits the investor and other interested parties. The principles for evaluating investment projects, based on the characteristics of the business model, are based on the use of special methods for calculating key indicators. Consider them.
Calculation of indicators
In practice, indicators are usually calculated using discount methods. That is, the size of the weighted average capital is taken, or, if it is more suitable from the point of view of the business model, the average market profitability for similar projects. There are discount methods based on bank rates. That is, the profitability of the project is compared, as an option, with profitability when placing a similar amount of cash on a bank deposit. As a rule, such indicators for evaluating the effectiveness of investment projects also take into account inflation or related processes, reflecting the depreciation of assets that are especially important for the investor.
We now turn from theory to practice. Consider how the evaluation of investment projects is carried out on the example of the analysis of some of the criteria indicated above. Let's start with the payback period. This is one of the key indicators by which investment projects are evaluated. If, for example, the other criteria of the two business initiatives being compared are the same, then preference is usually given to where investments will quickly go to zero.
Payback Analysis
This criterion is the time interval between the moment of launching a business project (or financial tranche of investor’s investments) and fixing the event when the total amount of accumulated net profit becomes equal to the total amount of investments. Some experts add one more condition - the trend characterizing the exit of business “to zero” should be stable. That is, if in some of the months after the start of the business, the accumulated profit became equal to investments, and after some time again the costs exceeded the revenue, then the payback period is not fixed. However, there are analysts who do not take this criterion into account or take it into account in the framework of complex formulas with a large number of conditions.
In what cases is an investor inclined to make a positive decision based on the analysis of the payback period? Experts identify two main cases. Firstly, if, in relation to this period, a profit equal to or comparable with the minimum discount rate on an annualized basis will be received faster than in 12 months. That is, relatively speaking, if in 10 months of the project implementation the investor receives a 15% return equal to 15% per annum in the bank, he would rather invest in the project than open a deposit, so that for the remaining 2 months upon the release of capital, they will invest somewhere else sometime. Secondly, the decision to invest in a business can be made if the investor considers the payback period acceptable, provided that the risk assessment of the investment project does not identify factors that could affect the decrease in profitability. Such cases are mainly characteristic of economies with low inflation and low volatility of the exchange rate (and, therefore, with low interest on bank deposits) - then investors are more willing to consider investments in real business, paying more attention not only to profitability, but also to risks.
However, the assessment of investment projects, based only on the payback period, is insufficient. Mainly because in this case the profit that can be received after the proceeds exceeds the costs is not taken into account. Relatively speaking, it may well turn out that the investor, having received 15% and withdrawing capital, will miss the opportunity to earn another 30% over the next year.
Net present value
As we said above, indicators of evaluating the effectiveness of investment projects include such a criterion as net present value. It represents the difference between the expected revenue and the size of the initial investment in the business. That is, it reflects how much the total capital of the company can grow. The investor will give preference to the project in which the net present value is expected to be higher with the same level of risk and for the same time period. At the same time, the payback period may not be taken into consideration at all (although this does not happen often).
Internal rate of return
The above indicators for evaluating investment projects are often supplemented by such a criterion as the internal rate of return. The main advantage of this tool is that the investor’s profit can be calculated without taking into account the discount rate. How is this possible? The fact is that the internal form of profitability assumes compliance with the very discount rate, but at the same time, the amount of expected revenue will coincide with the size of the invested funds. Relatively speaking, an investor, having invested 100 thousand rubles in a project, can be sure that he will receive at least the same amount after a predetermined period of time, as well as a “premium” that suits him, based on the chosen discount rate.
Modified Rate
An assessment of the investment attractiveness of a project can also be supplemented by a criterion such as a modified internal rate of return. It can be used if, for example, the net present value is negative (less than the selected discount rate), although other indicators are positive. For example, the usual internal rate of return. That is, relatively speaking, an investor, having invested 100 thousand rubles in a specific period of time, returns them with a premium of 15% after 10 months of business operation, however, after 24 months, the overall profitability of the enterprise is 1-2%. In this case, it becomes necessary to adjust the internal profitability based on periods when the revenue is not enough to satisfy the criterion at the discount rate, up to fixing the net loss. Thus, it is important for an investor to know: maybe it is better for him to invest 100 thousand rubles on the conditions of repayment with interest in 10 months and make 15 thousand, than to direct finances into circulation for 24 months and only 1-2 thousand rubles.
Profitability index
Economic evaluation of investment projects, as a rule, involves the inclusion in the analysis of such a criterion as the profitability index. This parameter allows you to determine how much, on average, all investors will receive (or the only, if all of the firm’s capital is) profit after a specified period of time, based on the initial amount of funds sent.
Quality criteria
Above, we examined rational, quantitative criteria by which a financial assessment of an investment project can be made. At the same time, there are also quality parameters. They are quite difficult to express in numbers (although in some aspects, of course, it is possible). But they are often no less important than the "formulas", which take into account the parameters that we studied above. What criteria are we talking about? Experts distinguish their following combination.
Firstly, the business project under study should be balanced, take into account the objective market conditions, and meet the stated goals. Secondly, the intentions and expectations of the entrepreneur should be adequate to the available resources - personnel, fixed assets, sources of financing. Thirdly, a proper quality assessment of the risks of the investment project should be carried out. Fourth, the company should consider the possible impact of the implementation of the business initiative on non-economic sectors - society, politics at the regional or municipal level, the environment, and analyze the image effects.
Profitability Factors
Actually, where do the figures come from that are substituted into the “formulas” for determining rational criteria, on the basis of which the investment attractiveness of the project can be evaluated? There can be many data sources. Let's try to determine what their nature may be. Experts identify two main groups of factors affecting the "variables" for the "formulas" in relation to rational indicators - those that affect the size of profit, and those on which costs depend. At the same time, this classification is variable in that the same factor can simultaneously contribute to the growth of the income of one company and at the same time complicate the business for another. A simple example is the ruble exchange rate. Its growth is very beneficial for exporters - their revenue in Russian national currency is growing. In turn, importers have to significantly overpay. Besides currency trading, what other factors can be cited as an example?
This may be an increase or decrease in capacity in a particular market segment, and as a result, sales will increase or decrease. As a rule, this is due to the emergence of new players in the industry, mergers, bankruptcies, etc., in some cases - state policy. Another factor is the increase in the costs of the company due to inflationary processes, changes in the market stability of suppliers and contractors. An example is the influence of technological processes - the introduction of certain sales tools or in production can significantly affect the overall dynamics of revenue in a business. As a rule, newer equipment involves a reduction in the technological cycle. As a result, the product enters the market faster. The assessment of the cost of an investment project with a more advanced production base may turn out to be higher than that which involves the use, albeit reliable, but more conservative in terms of the dynamics of the output of equipment goods.
Additional criteria
There are also indicators for evaluating investment projects, which are not so much of an economic nature as are based, to a greater extent, on accounting principles. That is, it examines how efficiently the company has set up accounting, how it regularly evaluates and re-analyzes the cost of fixed assets, and to what extent document management within the company and with partner organizations and government agencies is effectively established.
It is also possible economic evaluation of investment projects at the macro level. That is, there is an analysis of a combination of factors that can affect the prospects of a business, based on the state of the national or global market. In some cases, specific legal considerations are taken into account. That is, if, for example, at the level of sources of law at the federal level, private adjustments are possible in the aspect of customs legislation (for example, a ban on the import of certain goods from abroad), then the investor may consider it inappropriate to invest in such and such a business, despite that the calculated profitability and profitability indicators are very promising.
Not only a financial evaluation of the investment project can be carried out, but also, for example, an analysis of the identity of the business owner at the level of psychology, his connections, recommendations of other market players. A variant is possible when an investor makes a decision based on his personal attitude to a person who is considered as a candidate for business partners.
It is also possible that investment prospects will be evaluated based on the recommendations of other market participants, industry ratings, the frequency of brand presence and company executives in the media. If we are talking about serious investments, an investor, as a rule, uses an integrated approach in evaluating an investment project.