Next to someone who once taught calculus, or someone like who read thousands of spreadsheets and predicted the 2007 housing crash, even the most confident can feel like a klutz with numbers.
But if you work in investing or finance, or even if you do the occasional bookkeeping for your own auto shop, numbers are your daily bread…and we just know that our 8th-grade algebra teacher is rubbing her hands and giggling in revenge.
Ha, ha, Ms. Fleischman.
But as it turns out, very few investors are math geniuses.
Rather, and like any banker, tax specialist, entrepreneur, or sharp-minded business owner, investors know exactly what formulas and instruments will calculate their financial positions, and chart where those positions might (but pretty often don’t) trend over time.
Of course, we might think… that’s their job.
While we’re probably too busy to bother, they have to know how to do that.
And where we all hate burning mental calories when there’s a shortcut—and number of people ready to pick stocks or crunch the numbers for us—there’s a good case for staying in one’s lane and letting someone else parse the nitty-gritty.
Except that might put them in the driver’s seat…and when we have an idea or when we see an opportunity, we’re that much more likely to not even know what we’re looking at.
Investment Tools Give You Objectivity
You have a plan, an investment strategy with a return in mind.
But how do you objectively evaluate your options?
With no grasp on what returns an investment might give us, it’s a lot easier to be shocked by the sticker price and then pass on the deal. But what if we shouldn’t have passed… and how do we even know?
In the same way that teaser rates and adjustable-rate mortgages are known for luring in people like bait on a fishhook, a high sticker price can do just the opposite—turning people off or scaring them away when it really shouldn’t. But just like a masterfully written book that doesn’t sell because of a terrible cover, things like sticker prices can trigger emotions that feel as persuasive as any factual argument…even when they’re dead wrong.
So how do we get away from emotion and get some objectivity? How do we analyze based on the truth rather than the price tag?
Three tools come to mind…three methods that financial experts use to compare, calculate, and decide on investments. And trust us…while a little math helps, you don’t need to be Sir Isaac Newton to apply them.
Tool One: Net Present Value
If you’ve got a set amount ready to invest, Net Present Value NPV will show you the estimated future returns in today’s dollars.
It’s a great tool to start with because an investment’s NPV factors in an annual rate of return, along with the number of years you’ll expect that return. Not too complicated, and perfect for getting a decent snapshot on what you’ll stand to make and how that amount compares to what’s in your pocket right now.
The formula itself isn’t too complicated; it involves subtracting the present value of future cash flows from the amount of initial investment. You can make your algebra teacher proud by doing the math yourself… but even if you go with an online calculator tool that charts out how many years and how much return per year you’re expecting, the takeaway is crystal clear. Excel and Google Sheets even have a built-in NPV function.
If your investment’s NPV is positive, there’s a competitive return on your money that exceeds the risk.
If it’s negative, there isn’t.
Unlike the payback method, which simply calculates when you’re likely to make back the money you put in, NPV factors in the reality that the buying power of today’s money is greater than the buying power of that same amount of money in the future.
Pros and Cons of Using NPV
Taking our cue from a killer NPV breakdown in the Harvard Business Review, here’s our list.
- NPV compares the value of your money now versus money in the future.
- Accounts for the time value of money.
- Accounts for number of years with that return.
- Great for giving managers a concrete number for comparing competing investments in today’s dollars.
- Used to compare returns on mergers and acquisitions where return is everything.
- Slightly less user-friendly than the payback method.
- NPV involves assumptions on the amount of investment and time of return.
- Assumes a constant rate of return…and return rates usually change over time.
All things considered, it’s a powerful, objective tool for making investment decisions with future returns in mind…even if it might be pretty hard to explain to someone plucked at random from the street.
Tool Two: IRR – Internal Rate of Return
If NPV is making sense, Internal Rate of Return (IRR) is the next tool you’ll want to check out. This one walks this same path, and even uses the exact same formula, (but with the NPV set at 0) to show you the percentage of return your investment will generate.
While IRR doesn’t spit out a dollar value like NPV, investors use it to estimate how profitable an investment is likely to be.
Just like NPV, you can drag the application of IRR along the sky in an airplane banner.
If the rate’s positive, your investment strategy’s looking solid.
Negative? Not so much.
Here’s another calculator to try out.
Pros and Cons of Using IRR
IRR usage comes with tradeoffs.
- Simple, clear-cut answer…in this case, a percentage.
- Great for estimating profitability.
- Easy to pair with NPV, or to use if you’ve used NPV to calculate a return on investment.
- Like NPV, IRR assumes a fixed investment amount and doesn’t account for future, unanticipated spending.
- Also assumes a steady timeline and consistent rate of return.
- The percentage doesn’t consider the size of projects/investments…this can be a problem if you’re comparing two projects with different capital requirements.
If IRR sparks your interest, read more on how to use it here.
Tool Three: ROI – Return On Investment
Finally, the big kahuna. The bottom line. The investment tool you’ve probably heard thrown around at board meetings, client onboardings, pitch sessions and even a golf course or two.
In truth, Return on Investment (ROI) gets more airtime because of its simplicity and finality.
Where NPV and IRR can account for the nuances of multiple annual (or even monthly) returns as well as the rate of return, ROI works great for predicting what you’ll make with a one-time investment.
Like IRR, ROI is a percentage: the amount gained minus total costs divided by the amount invested. So…a hundred dollar investment that, after expenses, returns one-fifty means an ROI of fifty percent.
If that’s not clear enough (and hey, no judgments here), there are calculators for that too.
ROI works wonders in hindsight, factoring in the initial investment, the expenses that came along with it, and the percentage gained as a bottom line. It’s great for snap calculations and mental pictures of how much you’ll make on something, given what you’ll invest.
Pros and Cons of ROI
Let’s see …
- It’s a classic used by most businesses, most financial sectors, and among people who don’t have a finance or accounting background.
- Simple to calculate.
- Great for ranging projects in a clear hierarchy, from most profitable to lowest profit.
- Great for the big picture of maximizing profit with all available (and limited) resources.
- Gives a snapshot of the external project that will generate profit along with the internal project that might be driving the external one.
- ROI could be positive, but still be a bad investment. ROI ignores the time value of money, and the fact that today’s money has more buying power than the same amount of money in the future…(don’t forget that NPV and IRR pick up the slack with that one).
- You can’t assume you’re comparing apples to apples. Since different companies calculate ROI differently, you might be seeing two, totally different ways of looking at an investment..
NPV, IRR, and IRR make a decent Swiss Army Knife.
They’re a tool that any investor, entrepreneur, or business owner should get some practice with—and at the very least, learn to use carefully. Over time and with enough practice, they lay out clear, user-friendly pictures of where a project, a launch, or a financial investment might stand in the short or long term. And while there’s no harm in paying someone to run the numbers for you, you’re a lot less likely to be jostled by what they tell you if you know some of their moves.
And with objectivity on your side, that sticker price will probably look a lot less intimidating.
Garrington Capital Drives Opportunity
And when we’re not closing deals that drive entrepreneurs the capital they need, we’re driving as much opportunity through financial self-education as we can.
If you found this article helpful and if you’d like more helpful info that will help you reach your investing or lending goals, check out more of our content here.
And if you’re looking for a personalized solution that will grow your business with working capital, give the Garrington team a call.