In order to assess project opportunities and make difficult trade-off and priority decisions about where to focus your limited resources, you need to be able to compare projects on a like-for-like basis.And since there’s just no getting around the fundamental challenge that all organizations should be sustaining themselves, at some point the projects we invest in should create value.
Therefore, you should make project valuation — estimating the value of your projects — a part of your decision-making process.
So what is the value of a project? It’s simple:
Value = Benefits − Costs
In previous articles I discussed estimating project costs (see “What Are the Real Costs of Your Technology Project?”) and project benefits (see “What Are the Real Benefits of Your Technology Project?”).
If you have both the costs and benefits of your project in dollars, the computation of value is very straightforward.
But what this definition is completely ignoring is time. And time has a major impact on the value of a project.
Let’s take two projects, A and B, as an example. All figures are expressed in thousands of U.S. dollars.
Project A | ||||||||
Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | Total |
Costs | 800 | 100 | 100 | 100 | 100 | 100 | 100 | 1400 |
Benefits | 400 | 500 | 400 | 300 | 300 | 200 | 200 | 2300 |
Project B | ||||||||
Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | Total |
Costs | 2000 | 1000 | 1000 | 1000 | 500 | 500 | 500 | 6500 |
Benefits | 0 | 0 | 3000 | 3000 | 2000 | 1500 | 1000 | 10500 |
Now we will have a look at how time influences the value of these projects.
Measurement Period
Let’s take one of the most used project valuation methods as an example: return on investment (ROI).
Return on investment (ROI) is a performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost.
To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio. In our case, the investment is our project. The return on investment formula is as follows:
ROI = (Current Value of Investment − Cost of Investment) / Cost of Investment
When we apply this formula to our project A we will get the following result:
Project A | |||||||
Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 |
Accrued Costs | 800 | 900 | 1000 | 1100 | 1200 | 1300 | 1400 |
Accrued Benefits | 400 | 900 | 1300 | 1600 | 1900 | 2100 | 2300 |
Value | -400 | 0 | 300 | 500 | 700 | 800 | 900 |
ROI | -50.00% | 0.00% | 30.00% | 45.45% | 58.33% | 61.54% | 64.29% |
And for project B we get:
Project B | |||||||
Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 |
Accrued Costs | 2000 | 3000 | 4000 | 5000 | 5500 | 6000 | 6500 |
Accrued Benefits | 0 | 0 | 3000 | 6000 | 8000 | 9500 | 10500 |
Value | -2000 | -3000 | -1000 | 1000 | 2500 | 3500 | 4000 |
ROI | -100.00% | -100.00% | -25.00% | 20.00% | 45.45% | 58.33% | 61.54% |
You see that, depending on what year you use for measuring your ROI, the results are totally different.
Time to Value
The time to value (TTV) measures the length of time necessary to finish a project and start the realization of the benefits of the project. One project valuation method incorporating this concept is the payback period (PB).
The payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, the payback period is the length of time until an investment reaches a break-even point. The desirability of an investment is directly related to its payback period. Shorter paybacks mean more attractive investments.
When we look again at Project A and Project B you see a massive difference in the payback period.
Project A has a payback period of 24 months, and Project B has a payback period of 42 months.
Time Value of Money
TVM is the concept that money available at the present time is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also sometimes referred to as present discounted value.
That is why some project valuation methods include the TVM aspect. For example, internal rate of return (IRR) and net present value (NPV).
Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.
The following formula is used to calculate NPV:
As you can see, the higher your rate of return “r” is, the lower the current value of your project. Typically the value for “r” is determined by management.
The internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does.
To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount rate (r), which is the IRR. Because of the nature of the formula, however, IRR cannot be calculated analytically and must instead be calculated either through trial and error or using software programmed to calculate IRR.
Generally speaking, the higher a project’s internal rate of return, the more desirable it is to undertake. IRR is uniform for investments of varying types and, as such, it can be used to rank multiple prospective projects on a relatively even basis.
Assuming the costs of investment are equal among the various projects, the project with the highest IRR would probably be considered the best and be undertaken first.
Cost of Delay
CoD combines urgency and value — two things that humans are not very good at distinguishing between. To make good decisions, we need to understand not just how valuable something is, but also how urgent it is.
I discussed CoD in detail in the article “What Is the Real Cost of Delay of Your Project?”. Depending on your urgency profile, your project end date can have a significant impact on the value of the project.
So what is the real value of your project?
An ideal project valuation method is one where all metrics will indicate the same decision.
Unfortunately, the approaches mentioned above will often produce contradictory results.
Depending on management’s preferences, your economic situation, and selection criteria, more emphasis should be put on one metric over another.
As explained above, there are common advantages and disadvantages associated with these widely used project valuation methods.
Nonetheless, you should use one or more of them in your selection process.
In a nutshell: Determining the dollar value of your projects is essential for selecting the right one. Value = Benefits − Costs, and is dependent on duration and urgency.