Macy’s CEO, Terry J. Lundgren, was quoted recently in the New York Times saying the most recent business school graduates are weak in math. In response to the knee-jerk reply of “That’s what calculators are for,” Lundgren stated, “I don’t think you should actually have to have a calculator for every decision that you make that has numbers attached to it. Some of that should just come to you quickly and you should be able to quickly move to your instincts about that being a good or not good decision.”
Amen! It is vital in business to have an intuitive feel for the numbers. It is important to have some idea of the order of magnitude of change in output that various changes in input should accomplish. I work in real estate and in finance. Net Present Value (NPV) and Internal Rates of Return (IRR) are major ways in which investment decisions are evaluated. Each method has its strengths and weaknesses.* In my heyday, my youth, I derived each formula longhand and did calculations step by step on paper just to make sure I fully understood each one. Nowadays people just punch numbers into an HP handheld and believe whatever comes out.
Proper analysis of investment real estate requires a pro forma, an estimate of income and expenses over a period of time, usually 5 to 10 years. A proper pro forma contains many formulas, usually linked, along with many estimates and inputs. I can create the template for a rough pro forma from scratch in a couple of hours, a complete pro forma with all the bells and whistles and looking crisp could easily take a few days. It is amazing how many people in real estate and finance have never created a pro forma from scratch and couldn’t to save their lives. I’ve told my COO that the requirement to be a financial analyst for The Collier Companies should include the ability to at least create a rough pro forma from scratch solo. Otherwise, how can you truly understand what you are doing? Any data entry clerk can input data; a true analyst understands the underlying process at an intuitive level.
I’m a big “back of the envelope” kind of guy. If the deal is so close that it does not pencil out on a napkin at the table, I’m pretty sure I don’t want to go for it. And I definitely need everyone working for me to have a deep, intense, innate feel for our business model. Then double and triple check your gut feel via sifting the deal numbers through a great pro forma.
* NPV and IRR strengths and weaknesses:
For NPV you have to choose a discount rate first and the method assumes that all payments occur at the end (or beginning) of the year or period. Also, the answer comes out in terms of an absolute dollar return, so you have to back into your return by adjusting your discount rate.
For IRR, it assumes that you can reinvest proceeds at the given IRR, which is rarely true. Also, if you have unconventional cash flows, you can get negative or varying IRRs. It is also possible to have eye-popping IRRs on small dollar amounts, say where the absolute dollar return is not large enough to justify the effort. IRR is extremely time sensitive: short periods pop it, long periods dilute it. Such is life. The IRR method also does not assess the relative risk of various returns.
To the extent that the choice of the discount rate is supposed to reflect relative risk of the investment, NPV is theoretically superior in assessing relative risk between investments. Caveat emptor.