Key Business Metric for Investment: ROE, ROI, or NPV?

Cases Finance Investment Practice cases
Anonymous A asked on Apr 09, 2020

Hi everyone!

I was posed a tough question in a case.

Scenario
- Our client is considering an investment in a solid business
- This investment gives us 15M in cash flow every year from year 1 to year 10 (total: 150M)
- Initial investment: 100M

Question:
1) Which business metric would you use to evaluate this investment? 2) [...] therefore, what's your advice?

My (shaky) answers:
1) Business metric
- I would use NPV (i.e. discounting the cash flows) for a 'r' rate either if we are considering this investment against another one or if we are sure about the 'r' rate.
- I wouldn't use ROI because it doesn't consider time-value and the investment is quite long in time. The same would apply for ROE (it could be interesting if 100M are split between Debt and Equity)
- I would in any case consider pay-back period, but only as an additional information, not as a 'go - no go' driver
2) Advice
Since NPV is > 0, we advise our client to proceed with the investment
(this was a hint after I correctly described the equation: r is 5% --> NPV = 16M with).

How could I have answered in a more 'advanced' o 'finance-savvy' way? Are there any other business metrics I should have suggested?

Thank you!

Dee

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on Apr 30, 2020
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Hi!

My answers in short:

  • NPV is good if you want to compare this investment against other investments which have different time horizons
  • ROI needs to be further defined: what can make sense here is to compare the internal rate of return (i.e., the average year-on-year growth rate that yields 150m from 100m in 10 years; you can calculate it with a CAGR formula); comparing IRRs of different investment opportunities yields the same insight as NPV
  • ROE makes sense if you want to compare different investment opportunities that differ with respect to their financing structure

Important if you are preparing for interviews: all of these concepts will be massively simplified during 1-on-1 interviews! You will never be asked to calculate a discounted NPV during an MBB interview for example. Understanding the principle is however helpful of course.

Cheers, Sidi

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Anonymous A on Apr 09, 2020
Sidi, thank you so much for this insight. Super-useful! I get your point: calculating NPV may not be needed, but your answer allows me to approach a suggestion about the adequacy of these 3 metrics in different situations

(edited)

Hello! Agree with Siri.

To add on top, indeed it´s key to verify this with the client / interviewer first.

If you could only ask one question at the beggining of the case -actually, don´t worry, you can ask many-, it would need to be this one, and can be phrased in different ways:

  • What is success for the client?
  • What is the client´s target with this comparison?
  • Are there any metrics or KPIs that the client is particularly concerned about?

Like this, you would know precisely which is the key thing for the client and, once you have compared both -as I see you did already, and I agree with the reasoning-, you can choose.

Hope it helps!

Cheers,

Clara

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Hi Dee,

first of all, I would clarify if there is any client objective; if so, I would use that to define the metric.

If there is no metric, you could either use ROI or NPV and compare with a benchmark. However, ROI considers Net Earnings / Investment, if you have just the Cash Flow you should calculate the Net Earnings first. Of course, with either metrics you should take into account the time horizon (knowing r for NPV or comparing the ROI with an investment related to the same number of years).

You cannot use ROE unless additional information is offered, since there is no data on the shareholder equity.

In terms of advice with the NPV, to answer you would need to know

  • The discount rate r
  • The alternatives available with the 100M investment

In a simplified case that ignores the discount factor and where NPV>0 is enough to proceed, you should suggest to go with the investment.

Best,

Francesco

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Sidi gave the best answer

Sidi

McKinsey Senior EM & BCG Consultant | Interviewer at McK & BCG for 7 years | Coached 270+ candidates secure MBB offers
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