Question

At a conceptual level what do you need to know about a project or a firm to tell whether it is expected to create value?

Answer 1

A project is expected to create value in future, if:

1) The Net Income is good as per expected returns, and it can pay off good returns to its investors (typically more than the expected rate of return). There are some parameters which can measure the pay factors of a firm like leverage ratios, EPS, Return on Assets, Payout ratios and Dividend Yield ratio. For a project we can measure its Net Income from the cash flow it generates over its life, or for a reasonable period of time.

2) For a project, we typically calculate the NPV from present value of its future cash flows and total investment, and if the NPV is positive, the project is said to be generate positive income. Amongst 2 or more projects, the one with highest NPV should be best option to invest into.

3) For calculating the firm's profitability, another method is used that is residual income calculation, which uses the Net Income less all obligations and reserves to be paid. This value is the actual potential of the firm to pay to its investors, and if based on this value, company can pay the expected rate of return then returns are good from that firm.

4) At a firm level, we can also determine from the total debt it holds as part of its investment. The Net Income can be good, but if the debt proportion is high, then the firm has to pay off interest portions to repay its debt which means that payout to investor may be lower, and in long run this may also affect the growth of the firm.

5) At firm level again, the movement of inventory is important. The company may produce at a good speed, production costs may be taken care of, but, the movement of inventory should also be at an equivalent pace.

6) For a project, value creation can sometimes be non-economic. For example, roadways or flyovers, there may not be any particular income to the authority, however, the value created can be measured in terms of utility and time. Another example can be that of a dam, there may not be a specific income to the nearby land owners, however, the diversion of water level can be life saving for their families, and hence the project may be required to be taken up.