CEO on Financial Analysis

As I have previously said, the number of problems and inaccuracies of the “Net Present Value” method, when used in a “Company based scenario”, is legion. One can have a field day poking holes in the credibility of even the most carefully prepared work. Just for the fun of it, let’s mention a couple more.

At Fiscal Year end, the profit is distributed into income tax, dividends, reserve funds and retrained earnings. The income tax and the dividends are sums that will be paid, and accordingly constitute new cash flows. The retained earnings and the reserve funds do not get paid, and accordingly are sums that remain in the company’s Bank account. So in some days they increase the positive balance (more “Interest Income” at 0.50%), in some other they decrease the negative balance (less “Interest Expense” at 6.00%), and in some other they are the deciding factor that turns a negative balance into a positive one. Their effect in the results of the next Fiscal Years cannot be incorporated into the calculation, because the “Net Present Value” method does not foresee in any of its steps the determination of a daily balance of the bank account. The same effect exists for income tax and the dividends, until their payment date. Again their contribution (“Interest Income” and “Interest Expense”) is impossible to be taken into account thru the NPV method.

There are tax laws (example: Greek Tax law 128/75) who’s basis of calculation is the daily balance of the bank account, and also take into consideration whether that daily balance is positive or negative. Since the NPV method does not calculate the daily balance of the Bank account, any calculation of cash flows resulting from such laws is practically impossible.

I’m sure that if you give it a little thought, you can easily come up with a dozen other problems.

Stick around, and we are going to see how professionals throughout the world do their work, and that in order to avoid the problems of the “Net Present Value” method, they took a step back in evolution of Financial Analysis calculation methods.

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This is the second example from my list of “top two problems of the Net Present Value method”, and my personal favorite one.

Let us say that an investor is evaluating (thru the use of NPV) to invest in the creation of a new company that will manufacture and sell a new product. After all relevant forecasts (sales, purchases, salaries, ads etc) are collected, they are entered in a spreadsheet and they are discounted to their value on the starting day of the investment. The collections are portrayed as positive, and the payments as negative. In the end all discounted values are added, and we see if the result is positive (profit) or negative (loss). On that, we base our decision whether to make the investment or not. Or at least, that’s how it went thru the method of NPV. Now, let us insert in the scenarios one new information and see what happens.

Low scenario: The investor contributes 1 mil USD as equity. In reality, we see that the project is underfunded, and accordingly will take bank loans to fund its operation. The result is that half of the gross profit will go to the Bank, for payment of “Interest Expense” (at 6%).

High scenario: The investor contributes 10 mil USD as equity. In reality, we see that the project is self sufficient and does not need bank loans. On the contrary it will collect some “Interest Income” (at 0.5%).

Mid scenario: The investor contributes 5 mil USD as equity. In reality, we see that the project will take smaller bank loans than the low scenario and accordingly pay less “Interest Expense” (at 6%) than the low scenario, and will collect less “Interest Income” (at 0.5%) than the high scenario.

Concerning the actual bottom line result, which is Fiscal Year end “Profit or Loss” (or even better, if you prefer, “Dividends Distributed”), we see that the three scenarios deliver three materially different results. All of the forecasts (sales, purchases, expenses etc) are the same in all three scenarios. Their only difference is the starting balance of the bank account (as it is affected by the investor’s contribution of equity).

With the use of NPV all three scenarios deliver the same result. The problem that creates that obviously illogical situation lies in the fact that the starting balance of the bank account (or for the matter its balance at any given moment) is not factored or calculated anywhere thru the use of the NPV method.

Stick around, and we are going to see more problems and inaccuracies of the “Net Present Value” method.

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This one is from my list of “top two problems of the Net Present Value method”. Imagine that you are evaluating a “Company based scenario” of an investment. In order for the problem to be more obvious, let’s keep the scenario very simple.

Usually we evaluate the creation of a new company on a 5 or 7 or 10 year time frame. However for the purpose of simplicity of the example, the duration of this evaluation is going to be for only one Fiscal Year (from Jan 1^st of 2011, till Dec 31^st of 2011). Also, let’s say that only one incident is budgeted to take place, and that is a sale of a service (i.e. no stocks of goods are involved). Let’s also forget about taxes, and let’s say that it takes place on June 30^th of 2011 (in the middle of the Fiscal Year), and it will get paid immediately by the customer (i.e. zero days of sales outstanding).

In that oversimplified example that takes place in the middle of the Fiscal Year, according to NPV theory, we must discount the collection by 6 months. I will not get into the issue of choosing the appropriate discount rate, as this problem has already been discussed. However, in a “Company based scenario”, the reality is that the investor does not receive the money on the collection day (June 30^th of 2011), but somewhere in July 2012 or August 2012, when the company distributes dividends to its stockholders. That’s 12-13 more months that have not been accounted for in the calculation.

I really wonder how many people have realized that the “Net Present Value” method, when implemented in a “Company based scenario”, is by its own nature inaccurate by a margin on 6-18 months (or on average 12 months).

But then again, if we depart from the above oversimplified scenario, and move into a more realistic one, we will see that not all discounting calculations are off by 12 months. This is relevant only to the part of the sum that contains a profit or a loss. So, in every collection and payment, we must determine the “Profit or Loss” that is included in its sum, and make the adjusted discount. There are two problems on that. The first problem is that the establishing of such a breakdown is not really feasible or practical. The second problem is that the situation has become so complicated and the volume of work so gargantuan, that the only practical thing to do, is to throw in the towel, and forget about NPV as a whole.

Stick around, and be entertained by a completely illogical result that can be achieved by the “Net Present Value” method.

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