Watching Back To The Future again recently, I was horrified to realize that, at the end of the movie, the professor and Marty use their time machine to travel from 1985 to…wait for it…2015. They traveled 30 years into the future, and I’ve aged 30 years since last seeing the movie.
Robert Zemeckis’s vision for The Future doesn’t exactly match the real 2015. There are no flying cars or hoverboards. But he did get some things right: we do have wall-sized televisions, tablet computers, and video conferencing. All in all, things have changed a lot since 1985.
But one thing hasn’t changed: firms are still using net present value (NPV) as a metric to evaluate the potential of R&D initiatives. NPV was first mentioned in the literature in 1907, according to historians. It’s survived 108 years because it does have its uses—as an indicator of investment potential and a summary of an initiative’s cash flow impact.
But for R&D evaluation, NPV is sometimes misunderstood and frequently misused. Let’s look at the good, the bad, and the ugly:
The Good
- NPV takes total costs and benefits into account.
- NPV is a useful way to distill the twists and turns of a profit and loss statement’s cash-flow driven analysis into a single, easy-to-digest, number.
- You can easily compare project NPVs and get a sense of the overall winners and losers.
- NPV takes the time value of money into account, providing a way to make sure funds expended in the future are seen as a little less dear, and funds earned in the future are a little less compelling, than funds spent and earned today.
- NPV can be risk adjusted to account for the possibility of failure.
- With expected commercial value (ECV), a variant of the standard NPV metric, you can account for the risks associated with different decision points in the product development process.
ECV allows the analysis to account for changes in risk and potential reward created by different NPD decision points.
The Bad
- NPV hides the total cost of each project.
Critics of NPV argue that it hides the total outlay of funds and people—two projects with an equivalent NPV could, in reality, have very different costs. A productivity ratio can address this: to create one, divide each project’s NPV by its total (future) project cost. This gives a good estimate of the productivity of your investment dollars. We talk more about these productivity metrics here and here. - The NPV is wrong.
We couldn’t agree more! NPV is just an estimate, and whether you try to forecast NPV as a single number or as a range, you’ll still be wrong more often than you are right.
The Ugly
NPV as the great filter
This is an appealing idea: rank all your projects by NPV and cull the weak—portfolio review done! Maybe not so fast. NPV has a lot to offer, but it should never be the only guide by which you manage the portfolio. Even if it were a perfect indicator of value, it can’t help balance the portfolio against strategic goals (you have strategic goals, right?), or allow for consideration of other factors, such as technology platforms, geography, market types, … or whatever other dimensions are relevant to your strategy.
To create a real, balanced portfolio, you should look at each dimension with your strategic goals in mind, then ensure you fund the most valuable projects within those strategic dimensions—and even then, NPV is only one dimension of that value.
Consider NPV alongside other metrics to build a nuanced view of a project’s value. (From the Enrich Analytics Platform)
NPV as the source of all useful knowledge
Setting the important goal of portfolio balance aside, NPV still shouldn’t be the only key indicator of project attractiveness. Instead consider NPV as the gateway metric—the metric that helps you decide whether you delve deeper. Looking at NPV alongside a few other key pieces of information, such as revenue and expenses over time, or other key metrics such as launch date and project risks, can give a more nuanced view.A product like the Enrich Analytics Platform can give you instant access to this information—which is important because, as we’ve noted before, even portfolio-level discussions regularly dive into the details of divisions, product lines, and projects.
A single-page view of the project revenue story can help guide excursions into project-leveldetails. This view from the Enrich Analytic Platform shows how it happens.
For some portfolios, a single page view of the entire revenue story, from segmentation to share to pricing to sales, is a great way to anchor project-level conversations in the facts used to generate the NPV. This interface takes you under the hood of the NPV to give visibility to the underlying assumptions.
One NPV to rule them all—even when uncertainty pervades the project
Unless you are in the potato chip business, I would imagine your R&D initiatives are rife with uncertainty: in the technology, in the manufacturing, and in the market and competitive response. The idea of using a single-valued estimate of NPV makes little sense in this context. You’ll broadcast a number that is deceptively precise, and you’ll be guaranteed to be wrong.
You’ll also miss out on a chance to have consensus-building, value-creating conversations about the uncertainties, which may translate into risks or opportunities. A process where you estimate how confident you are on each input to your NPV is a transparent, project-enhancing discussion.
NPVs are very good for what they’re good for, but early-stage projects don’t really benefit from an NPV analysis. Many early R&D projects lack a defined market segment, or even value propositions. There’s simply no data on which to calculate an NPV—it’s less than a guess.Instead look at these projects on basis of their technologies’ breakthrough potential, or their alignment with strategic long-term goals. But don’t NPV them out of existence. A scoring methodology might fit the bill here.
NPV may be defined with a discount rate and a stream of cash flow figures, but how you arrive at those parameters makes all the difference. Projects with varying time horizons, discount rates, and accounting methods, to say nothing of revenue forecast methods, will each have a very different basis for their NPVs. That means your NPVs will all be different—and not comparable. It may look like a single metric, but the NPV is this case is a custom creation. Nothing will give your portfolio process a bad name faster than a lack of comparability across project forecasts.
Using NPV the Right Way
Each year, tens of billions of dollars in R&D investments are shaped, allocated, and refined with the help of Enrich’s EAP. Are you interested in learning how we can help streamline your portfolio reviews, turning months of long nights and frustration into a value-enhancing, confidence-affirming exercise for your R&D organization? Contact us, and learn what our clients already know about the value of the Enrich Analytics Platform.
