Running the Numbers

How to use financial metrics for big projects

After my last entry, I continued to cogitate on the economic criteria for funding projects. The more I look a this topic, the more deserving of attention it becomes. Let's start out with the basic proposition that there are three categories of project types. I know that this is simplistic, but it does help to consider the issues. Here are the three:

1. Profit Center Projects - these projects generate revenue and are nearly always run from within a profit center. These projects hit both the revenue line and the cost line, and thus the bottom line. The entire professional services industry (over $250B in the US) functions based on the performance of these kinds of projects.

2. Cost Center Projects - these projects are considered operational costs and typically fall under the expense line in an organization. They represent investments in the business, and might include IT, Operations, Facilities, etc. Depending on your particular brand of accounting magic, they might also include R&D. When someone says that "IT is a tax on the business," this is what they mean.

3. Economic Value Projects - these projects are conceived from the beginning as generating some kind of return on investment over time, usually 5 years. Unlike Profit Center Projects, these projects might run in the red for years before they turn black. Examples might include private equity investments, new product lines, acquisitions of other companies, etc.

Now, when we look back at our original question of using financial metrics for evaluating projects, we can see right away that these three different kinds of projects have quite different assumptions about how those numbers should operate.

What kinds of performance metrics do we tend to use for these three kinds of projects, assuming we use any at all? Here are the usual three for each of the three types:

1: PCP: These projects tend to be measured in terms of long term profitability and short term free cash flow. If the business only does billable services, they better generate profitable cash flow right off the bat or you will be out of business fast. Other performance metrics are resource utilization and resource realization.

2. CCP: These projects are usually measured in terms of "On Time, On Budget, On Scope." There has been loads of debate on this topic, based on the notion that there is no such thing as an IT project. There are only business projects. This is a great principle in theory. In practice, it doesn't appear to fly for one simple reason. IT is in fact a trapped service provider and should not make decisions about what to fund.

3. EVP: These projects tend to use the whiz bang financial tools such as EVA, NPV, NCF, IRR, all of which are essentially based on CAPM methodologies. The challenge here is that these methodologies have not proven to work, even in supposedly efficient markets.

On the use of CAPM, here's Eugene Fama, the creator of the Efficient Market Hypothesis: “The CAPM is still widely used in applications, such as estimating the cost of capital for firms and evaluating the performance of managed portfolios. It is the centerpiece of MBA investment courses. Indeed, it is often the only asset-pricing model taught in these courses….ultimately, the empirical record of the model is poor – poor enough to invalidate the way it is used in applications.”

But what about new ventures?  As my friend and colleage, Ezra Roizen, says, "I agree that for an established company valuation is a direct function of cash flow - but for any emerging venture it doesn't work - largely because new ventures should be focused on consumption over financial performance...and CAPM breaks down fast when you have to push the value out years in the future... It’s a bit like trying to tether a fighter jet to a battleship."

So I come back to my original argument. You absolutely must run the numbers but be wary of magical formulae that provide neat answers.

(Image source:  waxcom)