What is return on investment ROI?
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, return on investment essentially compares the magnitude of investment gains directly with the magnitude of invesment costs, for a specific time period. The return on investment calculation produces a ratio (e.g. 0.240), usually expesed as a perentaage (e.g. 24.0%). For the investment in view, a return on investment ratio greater than 1.0 means that gains exceed costs. Equivalently, an ROI result less than 0% signals a net loss, while an ROI greater than 0% represents a net gain..
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 return on investment figures are often produced and used by those with a poor understanding of the metric's strengths, weaknesses, and unique input data requirements.
Simple ROI is sometimes said to measure profitability. Some business people, however, borrow a term from the field of economics and say that ROI 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).
- What is return on investment ROI?
- What is the meaning of the return on investment concept.
- 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?
- When should the return on investment ROI metric be used?
- When should ROI not be used?
- Should return on investment ROI be calculated from discounted cash flow (present value) figures?
- How is ROI used for evaluating business case scenarios?
- Which 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 cash flow and financial statement metrics: see Financial metrics.
What is the meaning of the return on Investment concept?
The meaning of the return on investment metric is implied in its name. The metric 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 value 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. The metric calculated 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 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, then present the results as a percentage, as shown in the example ROI formula below:
The return on investment formula seems simple, but the calculation is not always as straightforward as it looks. The challenge in finding ROI for any investment or action is determining which costs and which gains belong in the calculation. The calculation should include only costs and gains caused by the action or investment.
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--not from multiple causes. 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 shows how the ROI metric is used to compare two investments (or actions) competing for funding. In the examples immediately below, the ROI calculation is applied to the expected cash flow streams for each investment. Examples in next section ("How does ROI compare to NPV, IRR, Payback, and other financial metrics?" ) compare 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:
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:
Two cash flow streams compared, one investment with larger returns early, the other with larger returns later.
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. The analyst must also be able to affirm that cash inflows and outflows in the first two rows of each table are caused by (follow from) the investment or action, only.
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, the ROI metric is found for the the end of year 3, for case Beta is given as . . .
Return on investment calculation at the end of Year 3. Note that the individual cash outflows (costs) for Years 0-3 appear both above the line and below the line. Individual cash inflows for Years 0-3 appear only above the line.This illustrates the reason that ROI cannot be calculated with annual net cash flow figures: with the net cash flow figures alone, it is impossible to know the magnitudes of the inflows and outflows.
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 figure of 35.9% is better than Alpha's figure, 3.1%.
- Comparing 5-year results, Case Beta still has a large advantage with an ROI at 51.1%, vs. 29.5% for Alpha.
The 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 another important point about ROI and decision support: For most business investments or actions, there is not a single metric result independent of the time period. Major actions in a complex business environment typically have financial consequences extending several years or more, and the calculated metric can be different every year. ROI for the action is not defined, that is, until the time period is stated.
When should return on investment ROI be used?
ROI should be used when the metric can usefully address questions about investments and decisions such as these:
- Should we make this investment or should we not make the investment?
- Does the investment return a net gain or a net loss?
- What is the profitability of this investment? This is equivalent to asking: What ROI should I expect for the investment?
- Which of several competing investments is the most profitable? Which investment option should we choose?
When should ROI be used to address these questions? A short and fast answer is to say that ROI should be used only when the appropriate cash flow data for calculating ROI can be obtained. That is, ROI should be calculated only when all investment costs (cash outflows) and all investment returns (cash inflows) are known.
- ROI can evaluate very simple investment situations, which have only one cash outflow and one cash inflow.
- More often, however, ROI is used for investment scenarios where there are multiple cash inflow/outflow events across the investment life.
Simple two-event investment
For simple investment scenarios, having only one cash outflow and one cash inflow, ROI data requirements are simple: (1) The cash in flow figure and (2) the cash outflow figure.
As a simple example, consider the question:
What is the ROI on a gambler's winning bet on a horse race?
In this example, immediately before the race, the bettor places a $10 bet on Horse #4 to win. and then, a few minutes later, #4 finishes first. The payoff for a winning bet depends of course, on the "odds" in effect when betting windows close, but suppose in this case the winning bet pays $24. For this simple investment:
ROI = (24 - 10) / 10 = 240%
There is one cash outflow ($10 bet) and one cash inflow ($24). Both events are caused by (result from) the investment, and the ROI application is valid. The ROI calculation is not concerned with the length of the time period between outflow and inflow. ROI itself is also not concerned with investment risks or the advisability of making such an investment.
The two-event ROI model can also be applied to other two-event investment questions such as these:
- What is the ROI on a non-coupon-paying bond investment?
- What is the ROI on work of art, purchased as an investment? (The two-event model assumes that owner costs besides purchase are negligible).
Complex Investment: multiple cash inflows and outflows over an extended time period.
The ROI metric is more often used in business to address questions about actions viewed as investments, having multiple cash inflows and/or cash outflows, which may extend across many years. Case Alpha and Case Beta examples above illustrate the multi year ROI approach. Here, all that is required are (1) The sum of investment costs across the total investment period, and (2) the sum of investment returns across the entire investment period. For Case Alpha, the inflow sum is $615 and the outflow sum is $475. Case Alpha ROI is calculated as shown:
ROI = (615 - 475) / 475 = 29.5%
This result should be described as the "5-year ROI" for Case Alpha. Designating the investment period is necessary in this case, because data were available for other investment periods as well (e.g., 3-year ROI).
The ROI result for the entire 5-year period is unconcerned with the timing of inflows and outflows within the designated investment period. This contrasts with other cash flow metrics including NPV, IRR, and Payback Period, which are impacted by cash flow timing within the investment period (See the section below, "How does ROI compare to NPV, IRR, Payback, and other financial metrics?")
Multi year (or multi period) return on investment calculations of this kind can address a very broad range of business questions, such as:
- What is the ROI for college education? For professional training?
- What is the ROI for an investment in a restaurant business?
- What is the ROI for a marketing program?
When Should ROI not be used?
The simple return on investment ROI metric should not be used when:
- Individual cash inflow and cash outflow figures are not available.
Analysts are sometimes presented simply with "Net cash flow" figures for each period. As illustrated for Case Alpha and Case Beta, above, however, net cash flow figures by themselves cannot reveal true profitability (ROI) of an investment.
- Comparing instments of different time periods.
A four-year ROI for one investment should not be compared to a seven-year ROI for another investment. Remember the advice, "Other things being equal, the better investment is the investmnet with the higher ROI." However, when investment ROIs for different time periods are compared, "Other things" are definitely not equal. Simple ROI is blind to timing factors better represented by metrics such as NPV, Payback Period, and IRR.
- There is no assurance that cash inflow and cash outflow figures are caused by the investment, and do not result from multiple causes.
This issue becomes especially important when using ROI to evaluate questions such as these:
- What is the ROI for a marketing program?
It may be relatively easy to measure costs due exclusively to the program, but in a situation where gains such as "increased sales" or "increased profits" may be result from multiple actions besides the marketing program.
- Which business case scenario has the better ROI?
Business case scenarios typically report cost and benefit estimates in terms of estimated cash flows. When comparing scenarios, however, it is important that ROI for the scenario be based entirely on incremental cash flow figures (the difference between one scenarios projected cash inflows and outflows) and another scenario, a baseline scenario, for estimated costs and benefits. (See the section below, "How is ROI used for evaluating business case scenarios?")
- What is the ROI for a marketing program?
Should return on investment ROI be calculated from discounted cash flow (present value) figures?
A few financial specialists prefer to produce the ROI metric from a discounted cash flow stream, that is, from inflow and outflow present values (PVs). Once you have the present value for each cash inflow and outflow, the ROI calculation itself is as simple as the calculation without discounting. However, many business people are unable to explain the meaning or proper use of ROI when the metric is derived this way, based on PV figures. This is no doubt one reason that the PV-based RIO metric is rarely used.
As an excample, consider these cash flow figures for Investment Case Alpha from above:
The present value PV ffor each inflow and outflow is calculated using end-of-period discounting and a discount rate of 8.0% (see the encyclopedia article Discounted Cash Flow for explanation and interpretation of the PV calculations). Using the sum of the inflow PVs (480) and the sum of the outflow PVs (398), the PV-based 5-year return on investment for Case Alpha, ROIpv, is calculated as:
ROIpv = (480 - 398) / 398 = 21.1%
Compares with ROI = 29.5% based on non discounted cash flow values.
Using PV figures derived the same way for Investment Case Beta above, the sum of Beta inflow PVs is (293) and the sum of Beta outflow PVs is (210). For Case Beta, ROIpv is calculated as:
ROIpv = (293 - 210) / 398 = 39.5%
Compares with ROI= 51.1% based on non discounted cash flow values.
Note that both PV-Based ROIs are lower than the corresponding ROIs based on non-discounted cash flow. Understanding the reasons for these differences is key to understanding what PV-based ROI can reveal about investment cash flow streams.
- The PV-based ROI can be either lower or higher than the corresponding non-discount based ROI, depending on which investment cash flows are impacted most heavily by discounting: investment costs (outflows) or investmnet returns (inflows).
- In situations where larger costs come early and larger gains come later, discounting typically leads to a lower ROI metric value than the same calculation performed on non discounted cash flow figures. In that case, discounting has a greater impact on the later large gains than it does on the early larger costs.
- Both example investments, Alpha and Beta, have "investment curve" profiles: larger costs come early, larger returns come later. However, for these examples, the impact on Alpha is greater. Using PV figures reduces Alpha's ROI by 28.5% (from ROI = 29.5% to ROI = 21.1%). The PV approach reduces Beta's ROI by 22.7% (from ROI=51.1 to ROI=39.5%).
In the net cash flow graph above for these cases, you can see the reason that Alpha suffer's the greatest reduction from discounting input data: Alpha is relatively "back loaded," i.e., the largest cash inflows come at the end of the investment period.
An earlier example for case Alpha simple ROI mentioned that "The ROI result for the entire investment period is unconcerned with the timing of inflows and outflows within the designated investment period." That statement does not apply to PV-based ROI, shown in this section. With PV-based ROI, cash flow timing impacts the magnitude of the discounting effect in the PV valuesthat go into the ROI calculation. PV-based ROIs for "front loaded" investment curves (e.g., Case Beta) compare more favorably to PV-based ROIs for "back loaded" cash flow streams (e.g.,Case Alpha).
It should not be surprising to learn that for many business people, paragraphs such as those immediately above seem "theoretical," but of little or no value practical value to those making investment decisions or engaged in business planning. In the interest of clarity and understandability, business analysts, investors, and decision makers in the real business world are better advised to leave time-value-of-money concepts to the metrics designed specifically to handle them: net present value NPV, internal rate of return IRR, and Payback Period.
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."
Cumulative cash flow curves for the net cash flow figures for Case Alpha and Case Beta. It is not possible to estimate simple ROI from these curves because they are built from net cash flow figures.
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 choice 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. 29.5% 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 value (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 return on investment 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.)
Which other financial metrics are also called ROI?
In financial 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 return on investment figures, or when asked to produce one, it is good practice to be sure that everyone involved defines the metric in the same way.