About why investment projects are not as good as they seemed when planning, even if they are based on accurate data.
Correct data does not guarantee success
The archives of our company contain about 200 prepared investment projects, many of which have reached a relatively successful implementation. This statistics is supplemented by data that we collect in open sources, as well as communicating with colleagues and clients. And if we analyze how much the prepared forecasts coincided with the actual results of the project, it probably will not be a surprise to anyone that on average the projects show a lower result than was predicted in the business plan. The reasons why this usually happens can be divided into four groups:
The project should not have given such a high result. This is the most common reason. A business plan is not so much an analytical document as a marketing document. it is prepared in order to interest an investor or convince a Bank. Therefore, forecasts are often deliberately put excessive optimism, while understanding that the investor will habitually add skepticism to the provided figures.
The appeal of the product was overestimated. The desire and ability to produce a product or provide a service is quite easy to generate confidence that everyone is just waiting for the moment to buy it all from us. Alas, the needs of customers and the way they make purchasing decisions need to be studied more seriously.
Important costs are missed or organizational and technical difficulties are underestimated. Also, in General, an understandable error in the analysis.
But there is another reason. It is popular, but often remains invisible or it is written off as an accident, although there is no accident here:
Opportunities and trends were evaluated correctly, but as the project progressed successfully, these opportunities became apparent to everyone and the business environment changed. New competitors appeared, buyers became too demanding, and suppliers raised their prices. This is something that is rarely taken into account in the analysis of a project, although even a superficial reflection on the basis of simple common sense suggests that this is how it should happen.
If we launch an investment project with an IRR of 30% on the horizon in 10 years, while the entire business around us is satisfied with, for example, an average return of 15%, it is logical to assume that other companies will sooner or later also become interested in this business. New competitors will come, who agree to 25%, but they will also deprive us of part of the profit, then new ones, and so on until there is nothing left of the excess revenue. And this perspective leads us to the question of the need to analyze not only the successful market state for us, but also the reasons why this state will remain or disappear during the project.
The study of microeconomics usually begins with rules and laws that govern (at least in textbooks) the market in a state of perfect competition or, conversely, monopoly. These two extreme States do not occur very often in real life, and studying them is quite boring. A company that is a monopoly plans its actions on the basis of primitive arithmetic. A company operating in a highly competitive environment does not plan anything at all, but simply accepts the existing conditions that lead it to profitability at the level of survival. In neither the first nor the second case, the company needs a market strategy.
But between these two extremes lies a large and diverse field, governed by game theory, pricing strategies, competition, partnerships, and other solutions that leave room for imagination. There are market structures that allow you, even without a monopoly, to earn a profit for years, which is significantly higher than the minimum level necessary for the survival of the business and the replacement of worn-out assets. And since monopoly is a rare exception, the company’s long-term success requires answering two questions:
how can we create a configuration in the market where we will always get a margin above the normal level – at the expense of consumers, suppliers or partners?
how can we not allow this configuration to change, and the market to slide towards perfect competition?
The problem with analyzing projects is that we often focus on the fact that a good configuration exists now. But we do not notice that this situation is completely out of our control, and perhaps the market itself, which allows you to earn 30% instead of the normal 15%, is doomed to disappear. This means that when evaluating the project, we need to further study what forces are operating in this market.
Porter’s market forces
Competition in the industry is our current chance to earn increased revenue. If the competition in the market for which we are preparing a project is close to perfect, that is, there are a huge number of participants who are poorly distinguishable from each other, and the buyer chooses them mainly by price, then our profit will always be at a minimum level, and any other forecasts in the financial model are most likely just an error in the preparation of data.
Important disclaimer! The minimum level of profit is not zero in the profit and loss statement,but the minimum economic profit, which also takes into account the cost of the attracted equity. In our calculations, this will mean NPV=0 at the average market discount rate.
If the competition is not perfect, then the industry has the opportunity to earn economic profit, and the NPV of projects can be above zero. Let’s call this a superprofit, because positive NPV values are what remains after deducting costs and normal, average market profits. But if such a superprofit has appeared in the industry, then there are two serious questions.
The first. It is impossible to get superprofits for a long time without attracting the attention of competitors. Horizontal forces enter the business and new market participants with the same product or with its substitutes come for their share. They will come as long as there is no excess profit left in the industry. Unless something stops them, unless there are barriers in the industry that prevent new entrants from entering the market. This can be the impact of government regulation, high investment needs, economies of scale, access to distribution channels, the importance of the brand when buying, etc.If there are no barriers, you can be sure that the industry will slide to perfect competition and excess profits will disappear.
The second question is who will get this super profit? Every product has a chain of creation and use, and there are many participants in this chain. Somewhere, on one or more links in the chain, the superprofit created around our product will settle. But will we be among these links? Our market will be under constant pressure from our customers and suppliers:
customers can reduce purchases or switch to substitutes in response to our price increases;
they can put administrative and political pressure on us to lower prices;
perhaps they just don’t know about us and product promotion is expensive, so we work with a small segment of a large market;
providers can use their monopoly position to increase prices or to deteriorate the conditions of supply;
suppliers or buyers can create their own production to replace ours, or threaten to create one to get better offers from us.
And so on. There would be a benefit, and there are many ways to take over the profit from the product. But they depend, of course, on the ability of buyers and suppliers to put all these strategies into practice. In other words, to sum up, a good market is one in which there is reduced competition, there are significant barriers to entry, and suppliers and buyers are weak and cannot act strategically. And only in this market, the planned revenues at the level of IRR=25-30% can last until the end of the project.
Market forces in the evaluation of investment projects
So, what does all this mean for evaluating investment projects? If the project is designed to get high IRR values, then in addition to evaluating the current state of competition and the current price level, the following questions should be included in the analysis:
Who is ready to enter this market now and who will be ready to enter it in the coming years? Do they have advantages? Can they afford to work with less profitability?
Are there barriers that prevent their entry? For example:
you can’t start small, you have to start large-scale production right away;
we control regulation in the industry and create rules that make it more difficult for new entrants to enter;
few people can get a loan on these terms, and production is capital-intensive;
our brand is very important to customers and they will not agree to a replacement;
we have access to unique resources that are not available to current and potential competitors.
If competitors can come to the market-how soon will this happen and how will it affect the profitability of our activities?
How concentrated are our customers? If one customer accounts for more than 10% of our sales, we need to develop a special policy for these customers, as they carry increased risk. A large (in terms of sales share) client has significant market power and can affect the effectiveness of the project.
How possible is it for us to find new customers? Do they exist at all, or are our products highly specialized and only needed by a small number of companies? And if they are, how expensive and complex is the process of promoting your products?
Do we have an alternative to all the suppliers we use? Are there any monopolists among our suppliers who can pay attention to the efficiency of our business?
You can add to the list, but the time and effort to analyze projects is not infinite, you have to stop at something. The answers to these questions will be enough to ensure that a well-prepared project describes not only today, but also the foreseeable future of the company.