Return on Investment ROI Explained
Definition, Meaning, and Example Calculations
Business Encyclopedia, ISBN 978-1-929500-10-9. Revised 2014-03-10.
Return on investment (ROI) is a popular financial metric for evaluating the financial consequences of individual investments and actions. Several different metrics are called by that name, but the best known is the metric presented here as simple ROI. As a cash flow metric, ROI essentially compares the magnitude and timing of investment gains directly with the magnitude and timing of costs. A high ROI means that gains compare favorably to costs.
ROI has become popular in the last few decades as a general purpose metric for evaluating capital acquisitions, projects, programs, initiatives, as well as traditional financial investments in stock shares or the use of venture capital. The metric is frequently used for such purposes, but decision makers and analysts should be aware that ROI figures are often often produced and used by those with a poor understanding of the metric's strengths, weaknesses, and unique input data requirements.
ROI is sometimes said to measure profitability. That description is accurate and useful. Some business people, however, borrow a term from the field of economics and say that it also measures efficiency in the use of funds. That usage is arguably less informative because the same term—efficiency—is used also to describe what is measured by quite a few different financial metrics, including Internal rate of return (IRR), Payback period, inventory turns, and return on capital employed (ROCE).
• The meaning of the ROI concept and return on investment
• How is ROI calculated for decision support and investment analysis?
• How does ROI compare competing choices and different cash flow streams?
• How does ROI compare to NPV, IRR, Payback and other financial metrics?
• How is ROI used for evaluating business case scenarios?
• Other financial metrics are also called ROI
- ROI for only the cash or capital portions of larger transactions: see Cash on cash.
- Measuring the value of professional training: see Return on investment for training.
- ROI metrics for company earnings from capital assets and equity: see Profitability.
- An overview of metrics for cash flow and financial statement: see Financial metrics.
The meaning of the ROI concept and return on Investment
The meaning of the return on investment metric is implied in its name. ROI addresses questions like these: What do we receive for what we spend? Do expected returns outweigh the costs? Do the returns justify the costs?
Most forms of ROI compare returns to costs by calculating a ratio or percentage. Usually, a result greater than 0 means that returns exceed costs, while a negative ROI mean that costs outweigh returns. When potential actions compete for funds, and when other factors between the choices are truly equal, the investment—or action, or business case scenario—with the higher ROI is viewed as the better choice.
Decision makers should remember that an ROI figure by itself is not a sufficient basis for choosing one action over another. A calculated ROI for a proposed action says nothing about the likelihood that expected returns and costs actually arrive as predicted. That is, an ROI figure says nothing about uncertainty or risk. It simply shows how returns compare to costs if the hoped for results arrive. (The same is also true of other financial metrics such as net present value or internal rate of return.) For that reason, a prudent analyst also estimates the probabilities of different ROI outcomes, and wise decision makers consider both the magnitude of the metric and the risks that go with it.
Decision makers will also expect the ROI analyst to provide practical suggestions on ways to improve return on investment by reducing costs, increasing gains, or accelerating gains (as suggested by arrows in the figure above).
How is ROI calculated for decision support and investment analysis?
Return on investment is frequently derived as the “return” (incremental gain) from an action divided by the cost of that action. That is the "simple" version of this cash flow metric, used for evaluating investments, business case results, and other actions. For example:
What is the ROI for a marketing program expected to cost $500,000 and deliver an additional $700,000 in profits over the next five years?
To calculate simple return on investment, divide the net gains from the investment by the investment costs. Present the result as a percentage.
Results such as the 40.0% figure above can be interpreted usefully when both the gains and the costs of an action are known and clearly follow from the action. In complex business settings, however, it is not always easy to match specific returns (such as increased profits) with the specific costs that bring them (such as the costs of a marketing program), and this makes the metric less trustworthy as a guide for decision support. ROI also becomes less trustworthy when the cost figures include allocated or indirect costs, which are probably not caused directly by the action.
How does ROI compare competing choices and different cash flow streams?
Several different financial metrics take an investment view of an action or decision, which means that each metric compares the timing and magnitude of returns to the timing and magnitude of costs. However each of the major cash flow metrics (ROI, Internal rate of return IRR, Net present value NPV, and Payback period), approaches the comparison differently, and each carries a different message. This section illustrates ROI calculations from cash flow streams for two competing actions and the next section (Financial metrics compared and contrasted) compares the differing and sometimes conflicting messages from different financial metrics.
Consider two five-year investments competing for funding, Case Alpha (A) and Case Beta (B). Which is the better business decision? Analysts will look first at the net cash flow streams expected for each case:
|Now||Year 1||Year 2||Year 3||Year 4||Year 5||Total|
|Net CF Alpha||–100||20||30||40||70||80||140|
|Net CF Flow Beta||–100||70||60||40||30||20||120|
Two features of these cash flow streams are apparent at once:
- Case Alpha has the greater overall net cash flow over 5 years.
- The timing of cash flows in each case is quite different.
The timing differences are even more apparent in a net cash flow graph:
Generally, important business decisions should not be made on the basis of just one financial metric. To answer the question, "Which is the better business decision?" the analyst will examine both sets of cash flow results with several financial metrics, including ROI, NPV, IRR, and Payback period. There is a serious disadvantage to net cash flow stream Alpha, however, that is not apparent in the net cash flow figures themselves. Among these metrics, that disadvantage is revealed only by ROI.
In order to calculate ROIs, the analyst needs cash inflow and cash outflow data for each period, not just the net cash flow figures. The tables below show these figures for each case:
For Case Alpha:
|Case Alpha||Now||Year 1||Year 2||Year 3||Year 4||Year 5||Total|
|Cash Inflows Alpha||0||90||100||125||145||155||615|
|Cash Outflows Alpha||–100||–70||–70||–85||–75||–75||–475|
|Net Cash Flow Alpha||–100||20||30||40||70||20||140|
|Cumulative CF Alpha||–100||–80||–50||–10||60||140|
|Simple ROI Alpha||–100.0%||–47.1%||–20.1%||3.1%||15.0%||29.2%|
For Case Beta:
|Case Beta||Now||Year 1||Year 2||Year 3||Year 4||Year 5||Total|
|Cash Inflows Beta||0||100||90||75||50||40||355|
|Cash Outflows Beta||–100||–30||–30||–35||–20||–20||235|
|Net Cash Flow Beta||–100||70||60||40||30||20||120|
|Cumulative CF Beta||–100||–30||30||70||100||120|
|Simple ROI Beta||–100.0%||–23.1%||18.8%||35.9%||46.5%||51.1%|
Simple ROI for each case, in each period, appears in the bottom row of each table. Applying the cash flow formula above to these data, ROI at, say, the end of year 3 for case Beta is given as
Using simple ROI as the sole decision criterion, which choice, Alpha or Beta, is the better business decision?
- Comparing 3-year results from each case, Case Beta's ROI of 35.9% is better than Alpha's ROI, 3.1%.
- Comparing 5-year results, Case Beta still has a large advantage with an ROI at 51.1.2%, vs. 29.2% for Alpha.
The ROI metric gives a very large advantage to Beta, even though Alpha has a larger 5-year net cash flow ($140 vs. $120). Why? Note that ROI is computed from periodic inflows and outflows, not from periodic net cash flows. Comparing cases, Alpha has much larger inflows and outflows than Beta. As a result, Alpha brings in more profits, but Beta is more profitable.
That reality is revealed by ROI, but hidden from other popular metrics such as NPV, IRR, and Payback, which are based only on net cash flows. Alpha's larger total costs have to be budgeted and paid, no matter how large the corresponding inflows. The business decision maker may simply be unwilling or unable to do so.
The example illustrates an other important point about ROI and decision support: For most business investments or actions, there is not a single ROI independent of the time period. Major actions in a complex business environment typically have financial consequences extending several years or more, and ROI can be different every year. ROI for the action is not defined, that is, until the time period is stated.
As a final consideration in calculating ROI, note that some financial specialists prefer to derive the result from a discounted cash flow stream, that is, from inflow and outflow present values. In situations where larger costs come early and larger gains come later, discounting typically leads to a lower ROI than the same calculation performed on non discounted cash flow figures. That is because the discounting has a greater impact on the later large gains than it does on the early larger costs. Using discounted cash flow figures thus leads to a more conservative, less optimistic ROI. There are "pros" and "cons" to both the discounted and non discounted approaches, and the business analyst should be sure to understand which approach is preferred by the organization's financial officers, and why.
How does ROI compare to NPV, IRR, Payback, and other financial metrics?
The different natures of example Cases Alpha and Beta are also apparent in a line graph of cumulative cash flow for each case. (Cumulative cash flow for a period is the sum of all net cash flows through the end of the period, the fourth data row in each table above. For more on cumulative cash flow and payback, see payback period.) In fact, some people refer to cumulative cash flow graphs such as these as "return on investment curves."
Which case, Alpha or Beta, is the better business decision? Each case has points in its favor, compared to the other, and decision makers ultimately will have to weigh ROI results along with several other metrics to decide which is best for their organization. Here are some points to consider:
- Total Net CF. Case Alpha outscores Beta in terms of 5-year net cash flow, $140 to $120. This is a point in favor of Case Alpha.
- ROI. Case Beta has the higher 5-year result (51.1% for Beta vs. 29.2% for Alpha). That is a point in favor of Beta. The ROI metric in fact shows shows Beta as the more profitable investment at every year end through the 5-year investment.
- Future performance. The cumulative curves above only cover 5 years, but if the resulting inflows and outflows are expected to continue beyond 5 years, the curves point to two different futures. By Year 5, Alpha's cumulative cash flow curve is heading skyward, while Beta's appears to be leveling off. If there is reason to believe these patterns will continue, that is a point in favor of Alpha.
- Payback period. The curves above show roughly the point in time when the cumulative cash flow "breaks even," that is, when cumulative inflows exactly balance cumulative outflows. This point on the horizontal axis is the payback period for each case. Payback for Case Beta is 1.5 years while Alpha's payback is 3.14 years. A shorter payback period is preferred because it means invested funds are recovered and available for use again sooner. The shorter payback period is also viewed as less risky than the longer payback. These are points in favor of Beta.
- Net present valuea (NPV). Using a 10% discount rate, Beta has a net present value (NPV) of $76.18, while Alpha's NPV is $70.51. With the time value of money rationale, Case Beta is worth more, today, than Alpha, even though Alpha will return more funds after 5 years. This is a point in favor of Beta.
- Internal rate of return (IRR). Internal rate of return (IRR) is the interest rate that produces an NPV of 0 for a cash flow stream. Case Alpha has an IRR of 28.9% while Beta's IRR is 44.9%. Financial officers usually view an investment with an IRR above their cost of capital as a net gain. When proposals compete for funds, the higher IRR is preferred. This is a point in favor of Beta.
Based on the financial metrics reviewed above, which action, Alpha or Beta, is the better business decision or better investment? There is no "one size fits all" answer, except to say that ROI is one factor decision makers and planners will consider, but they will consider other factors as well and give different weights to the different financial metrics above, based on (a) the company's business objectives, (b) the current financial situation (c) the riskiness of each investment, and (d) the availability of other investment alternatives.
How is ROI used for evaluating business case scenarios?
Which business case scenario should the analyst recommend? ROI and other cash flow metrics (Net cash flow, NPV, IRR, and Payback period) are often used to address such questions.
Financial business case analyses typically look forward in time, projecting estimated cash inflows (benefits) and cash outflows (costs) expected under each of two or more action scenarios. Note that one of the scenarios may be a "Business as usual" (or "Baseline" or "Do nothing" scenario). With two full value scenario cash flow statements, one for the Proposal scenario and another for Business as usual, the analyst can also construct an incremental cash flow statement, in which all figures represent the increment, or difference, between corresponding cost and benefit cash flow estimates in the other two cash flow statements. (For examples and more on business case cash flow scenarios, see the Encyclopedia entry business case cash flow statement.)
Only the figures in the incremental cash flow statement are appropriate for addressing ROI questions. The incremental statement represents inflows and outflows directly attributable to taking the action, in this case, implementing a proposal. On the other hand, figures in the full value scenarios may result from many causes besides taking the action proposal. (For example ROI calculations from business case cash flow statements, see Business Case Essentials.)
Other financial metrics are also called ROI
In inancial statement analysis—where analysts assess the financial health and business performance of companies—“Return on Capital Employed,” “Return on Total Assets,” “Return on Equity,” and “Return on Net Worth,” are sometimes called “Return on Investment.” In still other cases, the term sometimes refers to cumulative cash flow results over time. And, some people refer to other cash metrics as "ROI," such as average rate of return and even internal rate of return.
In brief, several different return on investment metrics are in common use and the term itself does not have a single, universally understood definition.Therefore, when reviewing ROI figures, or when asked to produce one, it is good practice to be sure that everyone involved defines the metric in the same way.
By Marty Schmidt. Copyright © 2004-.