How to find out if a project is feasible or not? Between two projects, which project will bring the most return? When will the investment be recovered? These are questions that investment analysis aims to answer through your valuation methods, allowing you to focus resources on what will bring your business the most value.
There are several ways for the company to increase its value to achieve better results. One of these ways is by analyzing investments, which clarifies the return on resources that have been or can be invested.
Also, making decisions that involve resource allocation requires a lot of study and knowledge about what is being analyzed.
It is necessary to make some calculations more accurate; after all, such data are essential for an enterprise because they demonstrate its ability to leverage and succeed or correct routes. This article will show you what investment analysis is, its importance, and the significant ramifications.
What is the Investment Analysis?
The analysis of investments consists of applying financial and accounting techniques to identify the feasibility of applying capital to the company at a given time and project. Thus, it is necessary to be careful and use the correct methods so that managers can discern the best decision to be made.
This analysis considers the project’s risks, whether those of an economic nature of market nature. We can estimate the return that will be obtained – positive or negative – and the manager can create strategies to get around the situation and get higher profits.
What is the Importance of Knowing how to Analyze Investments?
It is possible to cite several reasons why it is essential to analyze financial investments in companies.
Below, we’ll mention the key benefits for you to incorporate the techniques into your organization. Follow!
Monitor the economic and financial situation
With the investment analysis, you can visualize how your company’s financial situation indicates whether the capital invested in the project brought the expected return or if it was not profitable.
If the analysis is done after acquiring the project, the manager can know how his financial reality was acquired. If the result is not favorable, you can create action plans to reverse the situation in time.
Bring value to investors
There are people who, during their lifetime, have accumulated specific resources and use this capital to invest in companies with high growth potential. However, they request much information to know if their investment will bring good returns.
Enterprises with a fair investment analysis are more likely to receive this contribution, as they can prove their positive results and future growth forecasts.
Be attractive to potential shareholders
In the same way of adding value to investors, there are also companies in the stock market and want to generate value for shareholders. So they need to show their ability to grow and pay good dividends.
A reasonable shareholder will undoubtedly analyze the results to decide whether a given project is advantageous to its portfolio of investments in variable income. Therefore, having a report with the analyses that aim in the long term and a rate of return higher than the amount invested is essential for your venture to attract excellent and loyal partners.
Making the right decisions
It is common to find managers who do calculations without any formula or theoretical basis. Generally, they are the same that do not use financial planning, strategic planning, statements of results of the year, cash control, or any other management tool.
A manager spends much of his day making decisions to do what seems best for his company. Therefore, without foundation, there is a significant risk that the venture will break down due to misguided choices, mainly if they are not based on calculations and accounting or financial reports.
As we will see in the topic on the NPL (Net Present Value) method, two projects may prove profitable, but there is one that is most advantageous for the organization. Often, for lack of good analysis, the company chooses the least profitable.
What Information is Needed to do the Investment Analysis?
Before mentioning the formulas and techniques used in the analysis of investments, it is necessary to know some basic concepts applied in the methods: cash flow and the minimum rate of attractiveness (TMA).
Cash flow is one that measures the difference between financial inflows and outflows. It is carried out by accounting values such as depreciation and amortization should be discarded.
In turn, the minimum rate of attractiveness is the lowest percentage that the investment must return to be considered viable. It depends on external factors such as the SELIC index, the application time, the desired liquidity, and the risk that the company is willing to assume.
What are the Main Methods of Investment Analysis?
For useful analyses, different methods are cited by scholars in the area. Therefore, we will point out the main and most used. Check it out below!
The payback corresponds to the time that the initial investment will be recovered. Companies of various sizes widely use this method to organize their planning about the applications that an enterprise can make.
This method has the disadvantage of not considering what happens to the project after its payback. So it may be that the payback is relatively fast in some cases, but after that, it does not bring big profits to the company. Because it is a simple calculation, it is necessary to analyze other factors before making a decision.
The payback does not consider the company’s capital cost or the value of the money in time. Therefore, it is not so reliable, given the fluctuations that the value of invested capital can have for political or economic factors.
The most basic assessment of this technique is that the longer it takes to get the investment return, the less indicated it is.
Net Present Value (NPV)
NPV is often used for isolated and short-term investments. It represents how much the equity is worth when the difference between the present value of the expected payments and the initial amount that will be invested is calculated.
The NPL’s goal is to show that projects are worth more than they cost, so it is always expected that the result will be positive. Variables such as the minimum attractiveness rate are used.
- NPV greater than zero: viable project, with which the company will return;
- NPV equal to zero: project indifferent, as it will not result in either profit or loss;
- NPV less than zero: an unfeasible project must be rejected.
At the time of evaluation, it is necessary to look at some details because the LPV is measured in the absolute unit (number). Therefore, when comparing two projects to know which to invest in, the one with higher values may seem more feasible even if it is not the best in the relative unit (rate).
Internal Rate of Return (IRR)
IRR represents the expected rate of return for the investment made. This index is what makes the value of the inputs equal to the value of the outputs. To use this method, you must know both cash flow and minimum attractiveness rate.
Unlike The LPV, the result is in the relative unit, which makes this rate more used by companies to decide whether to invest.IRR considers the value of money over time, so it is more reliable than other methods that do not.
The disadvantage of this methodology is to consider that the value of cash flow will be reinvested itself. However, this rarely occurs, so there may be misunderstandings in the final result of the analysis.
- IRR greater than TMA: the project is feasible;
- IRR equal to TMA: indifferent project;
- IRR smaller than TMA: unfeasible design, so it should be rejected.
As IRR is measured in relative value (rate), it has the advantage of being able to compare the design of different deadlines and scales.
The profitability index (IL) is simple and can be used by any company, as it merely indicates whether it is profiting from the project. To this end, it expresses what the profit of that particular activity for the organization is.
The calculation is made by the relationship between the present value of the cash inflows and outflows. It can be applied only to analyze a project or visualize whether all projects’ set is profitable for the enterprise.
- IL greater than 1: the project is recommended;
- IL less than 1: The project must be rejected.
This method is one of the least used, but we brought the concept so that, in cases where the indexes already mentioned the conflict in the results, you have one more option to analyze together.
It serves precisely to compare, between two or more projects, which is the most viable to invest. For this, a comparative chart is made between the values until the point of intersection is found.
How to do the Calculations?
The calculations are performed using specific formulas according to the method. The different variables that impact each of them are used so that the results obtained are reliable when considering several factors.
It is indicated, however, to use the technology to your advantage. Therefore, it is safer to do the calculations in computer programs or excel spreadsheets since it is a delicate account. If done manually, that is, only with the HP calculator, it can cause errors that will decisively influence your company’s future.
If necessary, it is also possible to outsource this activity, leaving it in the hands of some consulting or specialized company. Thus, investment analysis tends to be complete since it will consider different factors before reaching an answer.
How to Compare Methods?
So far, we have learned that each method has its specific assessment. Therefore, for the project to be genuinely accepted and implemented,
it is indicated to have as results:
- Shorter payback time;
- Positive NPV;
- IRR equal to or higher than the minimum rate of return;
- IL is greater than or equal to 1.
However, there are cases in which some methods indicate accepting the project and others rejecting it. Because they are conflicting results, it is recommended to adopt The LPV as the most reliable response to making the decision. However, it is essential to analyze the project as a whole to reach the best possible conclusion.
It is also common for managers to seek to know and compare their indices with those of their competitors and the general market. However, knowing and understanding the reality of your own business is essential to find out the points of improvement and know-how to work on them.
Each index cited in this article on investment analysis has the function of studying the company’s projects’ scope. In this way, your enterprise will be ahead of the competition because you will know your weaknesses and know how to create strategies to improve them, reduce your costs, and increase profitability.
What is the Best Method of Investment Analysis?
After knowing some of the metrics to valuation aspects of companies and assets, many investors may wonder about the best investment analysis method. After all, everyone wants to use the best resources to determine whether an investment is worth it.
In this sense, it is necessary to divide this issue into two parts. That is, what would be the best investment feasibility analysis technique (IRR, RPL, or payback) and the best strategy in the financial market (fundamentalist or technical).
Tips: What is the best investment feasibility analysis technique?
Although many want to know the best investment feasibility analysis technique, unfortunately, there is no universal and straightforward answer. It is because each of the techniques addressed seeks to understand a different aspect of an enterprise.
The payback, for example, analyzes the return time relative to the initial investment. On the other hand, it demonstrates the project’s profitability, while the NPL calculates the present value of the project return.
In other words, each of these techniques presents the manager and the investor with different information. Therefore, it is not possible to define which would be precisely the best among these techniques.
In some cases, IRR may be more attractive, while in others, payback is more relevant to decision making. Therefore, it is necessary to evaluate all techniques to determine whether a venture is worth it.
Which is Better Between Technical and Fundamentalist Analysis?
Another issue that many debated among investors and speculators in the market is better between technical and fundamentalist analysis. However, this discussion does not need to belong; after all, there are already empirical results that demonstrate the failure of technical analysis and fundamentalist analysis’s success.
On the other hand, in droves, investors have enriched themselves in the stock market using the fundamentalist investment analysis strategy.
Some of these investors are:
- Warren Buffett;
- Charlie Munger;
- Luiz Barsi Filho;
- Benjamin Graham.
By observing these successful investors, there are two main characteristics between them: white hair or bald head. And this is no for nothing; after all, the success achieved in investments came over the decades and with the effect of compound interest on investments made based on fundamentalist strategies.
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Frequently Asked Questions
Risks can be classified as credit, operational, foreign exchange, interest rate, and financing. Risks associated with interest rate and foreign exchange add value.
Understand the long-term trend. Knowing only the short-term trend (in daily or intra-daily charts) can be a trap since these trends are often strongly influenced by long-term trends.
PayBack, Present Net Value (LPV), Internal Rate of Return (IRR), and Software packages are investment tools.
Remember that it is essential to significantly evaluate each investment’s viability when it directly impacts its cash flow. Using PayBack, NPL, and IRR makes this process more efficient and less risky.
However, calculation alone is not sufficient for decision making. Especially in software choices and significant changes, it is essential to consider indirect impacts, such as increased productivity and efficiency gains that ensure competitive advantage. Therefore, it is necessary to make a strategic analysis together with the financial one.
Have you been able to understand more about how investment analytics works? Leave below your questions and comments on the subject.