Resolving Conflicting Recommendations in Investment Analysis

Abstract

Investment worth or investment performance metrics guide us in making investment decisions. These metrics address specific aspects of investments such as value creation, investment efficiency, risk exposure and risk mitigation amongst many considerations. With the complexity of most investment decisions and the size and scale of many investments especially in the Oil & Gas Industry, it is not enough to look at one dimension of investment. For instance, while most people will look favorably at value creation, which is the central premise of most investment decisions, in the context of limited capital, it is also relevant to factor into decision making, the cost of such value created. In other words, net present value (NPV) which is the time-tested value creation performance metric for investors, will not suffice for most current managerial considerations, particularly when comparing two or more investments. How much value is created is usually juxtaposed with the question: at what cost? In which case, analysts must, of necessity present to Management or the Project Decisions Board, NPV along with other performance metrics, usually the discounted profit to investment ratio, (DPI) and Rate of return (ROR). DPI is value creation per unit of investment or a measure of investment efficiency. The two measures complement each other and expand managerial insights as to the efficacy or otherwise of the investment(s) under consideration. In contemporary investment analysis, more emphasis is placed on investment efficiency reflecting investor preference for ever higher return on capital employed. If the two measures each recommend a particular investment over another, then the decision to invest is straight forward. The problem arises when one metric recommends one investment and the other metric recommends another - a situation that we describe as conflicting recommendations. Which investment to choose will require factoring into the investment decision several considerations beyond just value creation and investment efficiency. Considerations such as available capital, the company's short- and long-term business objectives, other potentially available opportunities all come into play. This paper addresses issues arising from conflicting recommendations. We will highlight this problem by considering a simple example of two investments A and B of the same duration of five years and slightly different investment levels. We will limit our analysis to two popular investment metrics - Net present value (NPV) and discounted profit to investment ratio - DPI. The analysis presented is mainly deterministic and the investment opportunity space is limited to these two investments.