EXPERT RESPONSE
Each of these figures -- discounted payback, payback, NPV, ROI and IRR -- try to summarize a set of cash flows from a project into a single indicator. But as the dashboard on your automobile, one figure alone cannot tell you the entire investment story. Each has their intended purpose and strengths and weaknesses.
Discounted payback takes the time value of money into account. When an investment is made in a project today, that investment needs to return more in the future because $1 today is worth more than $1 in the future, since we live in an inflationary world. One must also consider that this $1 could have been invested elsewhere, especially in less risky investment vehicles, so not only does a $1 investment have to compete with inflation, but it competes with other opportunities. Thus to really break-even, $1 today has to return more a year from now, and even more two, three and four years down the road (as interest compounds).
With a discounted payback period, the costs and benefits of the project are discounted as they occur over time to take into account the lost opportunity of investing the cash elsewhere (usually set equal to a company's cost of capital) and further by a relative measure of the projects risk (the cost of capital + a risk generated discount rate). For projects with long payback periods, discounted payback periods are more accurate at determining the real payback, but for shorter projects, a non-discounted payback period is normally a good enough indicator. As with regular payback period, making investment decisions based purely on payback period can orient the team towards quick payback projects without regard to the ultimate benefit quantity – which is best measured using NPV.
Payback is one of the most common ways to assess the value of a project. Payback is calculated by comparing the cumulative cash investment in the project and comparing it against the cumulative benefits, typically month by month in a timeline. Most projects have a significant up-front investment, and then over time, this investment is recouped post deployment with benefits. Eventually, the benefits catch up to and exceed the initial and on-going investments required. The duration from initial investment to the point where the cumulative benefits exceed the costs is the payback period. Most teams like to see paybacks within 12 months or less, and some are even more demanding. Thus, one of the issues with using this as the sole determination of the project's worthiness, is that it can get the team focused on projects that only offer quick paybacks, without regard to longer term or more strategic investments. On the positive side, payback is often a good gauge for risk, whereby projects with longer payback periods are typically more risky – sensitive to cost overruns and delays at realizing planned values within the analysis horizon.
ROI and risk-adjusted ROI calculates the net benefits (total benefits – total costs) of a project divided by the total costs in a ratio to help highlight the magnitude of potential returns versus costs. An ROI of 150% means that $1 invested in the project will garner the investor $1 of their original investment back + $1.50 in gains. Risk adjusted ROI is the recommended ratio to use, and it tallies using the time value of money to discount the benefits and costs over time. Risk adjusted ROI provides a more conservative ratio, since benefits are usually higher than costs in outgoing years, thus the benefits are discounted and the ratio lower. Companies typically expect ROI of at least 100% to usually not more than 400% (although higher is possible). The ROI formula is great at comparing the costs to benefits in a ratio, but does not highlight well the timeliness of the returns, where payback period shines.
NPV is a formula that tallies all of the net benefits of a project (benefits – costs), adjusting all results into today's dollar terms. This is different than just tallying up all of the net benefits of a project over a three year period without discounting as the cumulative benefits without discounting overstate the overall project value, especially when the project has many of the investment costs up-front or in year one, and the benefits are not really kicking in until later years (where the time-value of money discounting reduces the overall value of these benefits). Net present value (NPV) is great at tallying up the net benefits over an investment horizon so that different projects can be compared as to the value they return to the company, but this metric alone does not highlight how long it may take to achieve the benefits (as payback period does). Nor does it highlight the ratio of the costs versus the net benefits, which is where the ROI formula shines.
IRR is one of my favorite metrics for comparing projects. Internal rate of return (IRR) is essentially the interest rate that the project can generate for the company, and is calculated as the discount value that when applied in the NPV formula drives the NPV formula to zero. Since internal rate of return (IRR) calculates the cash flow return for each project, investments in projects can be compared easily to other investment vehicles and to investment hurdle rates (returns vs. risks) established by the CFO. But IRR is not a great indicator as to the magnitude of investment needed, benefit value or payback, so the returns may be high, but the investment high, benefits not significant and/or payback (risk) too high.
As you can see, no one metric highlights all of the value strengths, weaknesses and risks of a given investment, especially when comparing several alternatives. I'd recommended that you use several of these indicators in conjunction -- including risk-adjusted ROI, payback period, NPV and IRR --along with investment required, risk score and business alignment score when assessing projects.
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