In theory, companies are good at allocating capital to the investments that will pay off the best. In practice, though, not so much. Managers use powerful tools like return on investment (ROI) to rank initiatives, which is a good idea, but the tools are outdated and don't match the reality of value creation today.
The challenge is that, while businesses may be relatively good at estimating the "I" side of the equation — how much cash is needed to do something — they don't capture all the value in the "R" (return) side. Businesses estimate what will come back to them in terms of cash each year, but what about value that's harder to measure, like employee or customer loyalty or reduction in risk? Most ROI calculations basically value all indirect or intangible benefits at zero.
In parallel, the other problem with ROI is that future benefits are radically undervalued. A rampant obsession with the short term has taken hold in business, making it hard for companies to invest in things that may pay off past this quarter or year. In technical terms, it means businesses use a high discount rate, making the future worthless. As asset manager Jeremy Grantham memorably said, "Your grandchildren have no value."
None of this is idle chatter — a lot is at stake. At the macro level, the business world is facing unprecedented change and volatility. The mega trends include demographic shifts, the rise of new global powers, technology advancements that are making the world more transparent and data-driven, and two interrelated challenges that I believe should take precedence: climate change (which brings extreme weather) and resource constraints, which drive higher prices for all inputs into the economy. If the business world doesn't aggressively tackle these two mega challenges, the others will be moot.
So, at a practical level, companies need to profoundly rethink their strategies and tactics to navigate this volatile world. This is the main idea in my new book, The Big Pivot. I propose that companies need to adopt a range of new strategies to manage the challenges companies face. Fighting short-termism and changing how investment decisions are made are two important elements of the story. (Others include asking heretical questions to drive disruptive innovation, setting goals based on science, and collaborating in new ways with governments, customers and even direct competitors.)
So, all that said, how can companies systematically take into account both indirect/unmeasured value and longer-term value? A few suggestions:
Set different hurdle rates for different investments. Recently, I heard an executive say that he wasn't sure the company should fund energy-efficiency projects that took four years to pay back. That use of capital, he said, would compete with other initiatives, such as entering the Russian market with one of the company's brands. But the comparison is odd, at best. The four-year payback estimate on the energy-saving project is based on physics, while the time to recoup the investment in Russia is, frankly, fabricated. Some companies have realized that different kinds of investments need different approaches, so they've changed the hurdle rate strategically. Intel, for example, uses a four-year payback for some energy-efficiency investments and a seven-year payback for "green building" projects (which sounds long, but not on a 50-year asset).
Use a "portfolio" approach. If you ask people in the organization to submit all the energy- and material-saving ideas they can, it can generate quite a list. Then, instead of just doing the quick-payback ideas, put together a larger group of investments, with some paying back fast and others longer. The full portfolio can meet the target hurdle rate on average. Cleaning products company Diversey, a division of SealedAir, used this approach to fund 90 projects at once, ranging from lighting retrofits (very fast payback) to deeper energy retrofits or the use of renewable energy (which, at the time, took longer to pay back; the economics have shifted fast on renewables). The total investment generated a higher net present value than just investing in the subset of ideas that met the hurdle rates the company had set.
Set aside funds. It's a deceptively simple move, but some companies — like DuPont, Owens Corning and Johnson & Johnson — have used dedicated funds to reduce energy, waste and material use. This approach helps companies tackle the "urgent versus important" problem that generally draws resources away from some solid, un-sexy investments in making the business more efficient in favor of other pressing priorities (like a new product or process). It's a bit like pulling some money out of your paycheck every month and auto-depositing it to make sure you hit your savings targets.
These are just some of the approaches that can work to help your organization invest for the longer haul, and they should be useful for companies of all sizes. Smaller, more entrepreneurial companies may have more leeway to think long term. They're not facing the same kind of investor pressure that big, public companies do.
But the challenge is for companies of all sizes to act more nimble, bend some rules about ROI, and build more efficient and resilient companies that can thrive in a volatile world.
Andrew Winston is a globally recognized business strategist, and author and founder of Winston Eco-Strategies. His latest book, "The Big Pivot: Radically Practical Strategies for a Hotter, Scarcer, and More Open World" (Harvard Business Review Press, 2014) helps business leaders navigate and profit from the world's biggest challenges. Follow Andrew on Twitter @AndrewWinston.