Page 4: Evaluating investment
Whenever investment decisions take place, there is a need to compensate those who take risks - whether they are lenders, managers or investors. Risk analysis helps to assess the difference between what an organisation plans to achieve and, given the probabilities of success, the likely outcome.
Although it can be argued that the future outcome of any decision is unknown, the probabilities of most outcomes can be estimated, using past and current events as guidelines. For example, the simplified risk analysis model for organisation growth shows that a high-risk venture would be a proposition which involved developing new products for new groups of customers. In contrast, a low risk venture would involve providing existing products for existing customers.
A relationship exists between the business risk taken by Bass and the financial risk. Business risk is influenced by the nature of investments – whether they are organic or acquisitive. Financial risks are determined by how Bass finances these projects. It is therefore critical to examine the life of each project. A ten-year organic development costing £50 million must make at least £5 million per year. Similarly, if an investment such as buying a hotel chain costs Bass £300 to £400 million, Bass therefore must use its investment to generate at least an extra £30 to £40 million per year to justify this investment.
Investment involves the immediate risk of funds in the hope of securing returns later. Organic development and acquisitions, designed to build and develop brands, have enabled Bass to gain synergistic benefits. Synergy is usually explained through ‘simple’ mathematics in the form of 2 + 2 = 5. It is used to emphasise that the sum of the parts of the organisations working together is greater than the individual components working alone.
A key element in the business strategy undertaken by Bass is to build leading positions in markets such as hotels, leisure retail and branded drinks which maximise value for shareholders. These strong distinctive brands should then place Bass in a position to grow the company over time, so that each year profits rise, the value of the company rises and the share price increases. At the same time, there should be the potential to decrease costs. For example, in 1998:
- Bass’s net capital expenditure was £587 million
- adjusted earnings per share increased by 3.4%
- dividend per share went up by 9.1%; operating profit from continuing operations 8.4%
- turnover went down by 12.3%.
Such results reflect the strong position of Bass and help it to be viewed favourably by investors in financial markets looking for steady growth from their investment over time.