How To Analyze An Investment Opportunity

Video Transcript 

My name's Robert Bonavito, New Jersey Forensic Accountant. This video is part of a series of videos where I discuss forensic accounting topics for educational purposes only. If this was a litigated matter, I would take a different approach, have different conclusions based on different facts and circumstances.

Hi, I'm Robert A. Bonavito, New Jersey Forensic Accountant. Today's topic is gonna discuss how to analyze an investment opportunity, and I'm gonna give you a very simple example, a framework that you can use when you're analyzing, buying a business, whether to take a job, whether to buy a car, pretty much anything you do you can use this framework. And this is gonna be simplified, but you can apply it to any situation, though the complexities will increase geometrically.

When you analyze investment, the framework we use, it's called net present value. And this framework, what it enables you to do is not only use, you know, calculations and do the numbers, and see if it makes financial success, but it makes you think about the narrative, about the business. Is it a profitable business, you know, what's our margins? That type of stuff, it's really good to do.

I'm gonna give you a simple example, let's say you want to buy a business for $200 million, okay? And you forecasted, let's say $500 million of cash flows for six years and after six years, let's just say the whole business goes away. So, first thing you'd have to think about is, what rate you would want on this business or what your discount rate is, and for this, I'm gonna use 6%.

So this is how we would set it up. In year zero, you'd spend $200 million on the business and the years one through six, the net cash flows from that business would be about $500 million, okay? And remember, we're standing in year zero, and we want to say whether we should do this investment or not. And what you would do is you'd just do a net present value calculation on years one through six at 6%.

Now when you do that calculation, you're gonna come up to about $460 million, okay? So all these cash flows, when I'm standing here in year six, I'm then gonna bring it back and have a net present value, and it's gonna exceed the cost by $460 million. So, if you're gonna have a positive net present value, you'd probably do that, make that investment from a purely financial standpoint.

Of course, I'm assuming that your discount rate takes into all the risk associated with the investment and the cash flows that you estimated are pretty accurate. And if they're accurate, well, listen, $460 million for a $2 million investment, you're gonna get your $200 million back, and then you're gonna walk away with $460 million in year zero with the net present value. And this is what we use and like I said, the more you use it, the better you're gonna get at it. And it's a pretty effective way to look at investment alternatives.

My name's Robert Bonavito, if you have any questions, feel free to email me.