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Return on Investment ROI
Definition, Meaning Explained, Example Calculation

 

ROI is a popular general purpose metric for evaluating capital purchases, projects, and programs, as well as investments in stock shares and the use of venture capital.

ROI metrics compare investment gains directly to investment costs.

What is Return on Investment ROI?

Return on Investment (ROI) is a popular financial metric for evaluating the financial consequences of investments and actions.The calculated ROI is a ratio, or percentage, comparing net gains to net costs. ROI is popular because, in this way, ROI provides a direct and easily understood measure of investment profitability.

Like other cash flow metrics (NPV, IRR, and payback) ROI takes an Investment view of the cash flowstream that follows from an action. Each of these metrics compares likely returns to likely costs in a unique way and, as a result, each metric carries a unique message about the cash flow stream. This family of metrics, therefore, provides several different ways to ask questions like this: Do investment returns justify the costs?

ROI Result As a Percentage

 

Investors and decision makers use the ROI metric to compare the magnitude and timing of expected gains with the magnitude and timing of costs.

In fact, several different metrics are called return on investment, or ROI, but the best known is the cash flow metric defined here as Simple ROI or the Return on Investment Ratio.

Simple ROI compares returns to costs by making a ratio from cash inflows and outflows that follow from the investment. By definition, the ROI ratio calculates as net investment gains divided by total investment costs.

  • Analysts normally present the ROI ratio as a percentage. When the metric calculates as ROI = 0.24, for instance, the analyst probably reports ROI = 24.0%.
  • A positive result such as ROI = 24.0% means that returns exceed costs. Analysts therefore consider the investment a net gain.
  • The opposite kind of result, a negative ROI such as –12.7%, means that costs outweigh returns. Analysts therefore view the investment as a net loss.
  • Consequently, when comparing two or more investments—and when risks and other factors are equal—the investment with the higher ROI is considered the better choice.

Return on Investment: Use and Misuse

ROI has become popular in the last few decades as a general purpose metric for rating capital purchases, projects, programs, and initiatives, and also investments in stock shares and the use of venture capital. Because the metric is popular and widely used, however, decision makers and analysts should remember that many who produce ROI figures have a poor grasp of the metric's weaknesses and unique data needs. With ROI figures from an unknown source, therefore, the wise decision maker will also ask to see the source data for those results.

Some analysts say that simple ROI measures profitability. While that statement is accurate and useful, other businesspeople borrow a term from the field of economics and say that ROI means efficiency. That usage is arguably less useful because many people use the same term—efficiency—to describe the meaning of quite a few other metrics, including Internal rate of return IRR, payback period, inventory turns, and return on capital employed (ROCE).

Explaining Return on Investment ROI in Context

Sections below further define, explain, and illustrate return on investment ROI. Note especially that the term appears in context with related terms and concepts, from the fields of business analysis, investment analysis, and finance. The following issues receive special emphasis:

  • Essential meaning of the ROI concept.
  • Calculating ROI for decision support and planning purposes.
  • Using ROI for competing proposals.
  • When to use and not use ROI.
  • ROI input data: Discounted vs. non-discounted cash flow.
  • ROI for business case scenarios.
  • Comparing ROI to other cash flow metrics, including NPV, IRR, and Payback Period.
 

Contents

Related Topics

 

What Does the Return on Investment Concept Mean?

The name of the return on investment metric describes its meaning. It is not surprising, therefore, that businesspeople use ROI to address questions like these: "What do we receive for what we spend?" And, "Do expected returns outweigh the costs? Also, "Do the returns justify the costs?" And, finally, "What is the profitability of the investment?"

The simple ROI metric answers these questions by making a ratio (or percentage), showing directly the size of net gains relative to the size of total costs.

  • Consequently, when total returns exceed total costs, net gains are positive, and the ROI metric is positive (greater than 0).
  • The opposite outcome (negative net gains) leads to a negative ROI (less than 0). A negative ROI signals, therefore, that total costs outweigh total returns and the investment is a net loss.

Thus, for example, a result of ROI = 10%, says that returns exceed costs by 10%. And, with a 10% ROI, the investor can properly say "the action earned 10% on costs," and that "profitability was 10%." In the same way, an ROI of -10% says that earnings and profitability were negative.

As a result, when different actions compete for funds, and when other factors between them are truly equal, decision makers view the option with the higher ROI as the better choice.

ROI Does Not Measure Risk

Decision makers should know that ROI figures alone are not a sufficient basis for choosing one action over another. That is because ROI simply shows how returns compare to costs if the hoped for results arrive. The ROI figure, therefore, shows expected profitability but says nothing about uncertainty or risk. Consequently, the wise analyst also estimates the likelihood of different ROI outcomes, and wise decision makers always consider both the size of the metric and the risks that come with it.

Decision makers will probably expect the analyst to produce ROI figures and also measures of risk, of course, but they will also expect practical advice on ways to improve return on investment by reducing costs, growing gains, and moving gains forward in time (as the arrows in the figure above suggest).

Calculating ROI For Decision Support and Investment Analysis

Analysts normally present return on investment as the return (net gain) due to an action divided by the cost of the action. That is the simple ROI version of the cash flow metric for rating investments, business case results, and other actions.

The analyst will probably receive the ROI request as a question such as this:

What is the ROI for a marketing program that will cost $500,000 and deliver an additional $700,000 in profits over the next five years?

To find simple ROI, divide the net gains from the investment by the investment costs, then report the result as a percentage. Here, marketing program ROI turns out to be 40%:

 

The return on investment formula seems simple but usage is not always as straightforward as it looks. This is because the challenge in finding ROI for any investment or action is knowing which costs and which return figures to use in the formula.

Note especially: Results such as the 40.0% figure above have meaning only when both the gains and the costs are clearly due to the action, only, and are not due in part to other causes. In complex business settings, however, it is not always easy to match specific returns (such as greater profits) with the specific costs that bring them (such as the costs of a marketing program). As a result, when the match between returns and costs is doubtful, the ROI metric loses validity as a guide for decision support. ROI validity also suffers when the cost figures include allocations or indirect costs, which are probably not due to the action.

ROI Compares Competing Choice, Cash Flow Streams

Sections immediately below show how ROI metrics compare two investment cases that are competing for funding. This represents a common situation, where decision makers must prioritize incoming proposals so as to choose those that will justify their costs, while denying funding to those that will probably bring lesser returns, as well as those that will even bring a net loss. As a result, Capital Review Committees, Project Management Officers, strategic planners, and others, routinely turn to metrics that take an "investment view," of proposed actions. When using ROI to compare two proposals, other things being equal, decision makers will probably choose the option with the higher ROI.

Note especially that other examples (in sections further below) compare these cases again, using ROI along with five other metrics. The purpose of the multi-metric comparison, therefore, is to show that different metrics can reach opposite conclusions on which case represents the better business decision. (see "How does return on investment compare to other financial metrics?")

Example Calculations: Return on Investment for Two Competing Investments

Consider two five-year investments competing for funding, Case Alpha (A) and Case Beta (B). Which is the better choice in business terms? Analysts will probably look first at the likely net cash flow streams for these cases: 

 Annual
 CF
Net CF Alpha
Net CF Beta
Now 
-100
-100
Year 1 
20
70
Year 2 
30
60
Year 3 
40
40
Year 4 
70
30
Year 5 
80
2\0
Total 
140
120

Notice two features of these cash flow streams that are apparent at once.

  • Firstly, Case Alpha clearly has the greater overall net cash flow over 5 years: Alpha's total net cash flow of $140 is greater than Beta's figure of $120.
  • Secondly, however, cash flow timing in the two cases is quite different. Beta seems to be "front loaded," which means that larger returns come in the earlier years. As a result, the analyst will want to know how the timing differences impact several different cash flow metrics.

Note especially that the timing differences stand out clearly in a net cash flow graph:

 

Comparing two cash flow streams: One investment has larger returns early, while the other has larger returns later.

Important Decisions Deserve More Than One Metric

As a rule, decision makers normally consider several financial metrics, not just one, when making important decisions. Consequently, to answer the question, "Which is the better business decision?," the analyst will probably review both cash flow streams with a set of metrics such as ROI, NPV, IRR, and Payback period.

Examples below will show, by the way, that Alpha's cash flow stream has a problem that is hidden by the net cash flow figures. Among these metrics, only ROI reveals this problem. Later sections show that ROI's unique insight has to do with the difference between profits and profitability.

Data Needs for Calculating Simple Return On Investment

In order to produce simple ROI, the analyst must have cash inflow and cash outflow data for each period, not just net cash flow values. The data tables above, therefore, must add columns with these figures, as well. Therefore, with inflows and outflows now in the first two columns, the tables suffice for producing proper ROIs. Decision makers should note especially, however, that metrics built from these numbers are "proper"—have clear meaning—only if the analyst confirms that these cash flows are due to the investment or action, and not to other causes.

Case Alpha Cash Flow Data

Alpha
Cash
Flows
Cash Inflow Alpha
Cash Outflow Alpha
Net
CF
Alpha
Cumul CF Alpha
Simple ROI
Alpha
Now 
0
-100
-100
 
 
Year 1
90
-70
20
-80
-47.1%
Year 2
100
-70
30
-50
-20.8%
Year 3
125
-85
40
-10
-3.1%
Year 4
145
-75
70
60
15.0%
Year 5
155
-75
80
140
29.5%
Total  
615
-475
140

 

Case Beta Cash Flow Data

 Beta
Cash
Flows
Cash Inflow Beta
Cash Outflow Beta
Net
CF
Beta
Cumul CF
Beta
Simple ROI
Beta
Now 
0
-100
-100
 
 
Year 1
100
-30
70
-30
-23.1%
Year 2
90
-30
60
30
18.8%
Year 3 
75
-35
40
70
35.9%
Year 4
50
-20
30
100
46.5%
Year 5
40
-20
20
120
51.1%
Total  
355
-235
120

Calculating Simple ROI for Alpha and Beta

The right column of the tables has the simple ROIs as they stand at the end of each yearly period. Therefore, using the cash flow formula above and Case Beta data, ROI after three years stands as 35.9%:

 

Calculating return on investment for case Beta at the end of Year 3. Note especially: that individual cash outflows (costs) for Years 0-3 appear both above the line and below the line, while cash inflows for Years 0-3 appear only above the line. As a result, annual net cash flow figures alone do not suffice for producing ROIs. This is because the net figures hide the individual inflows and outflows.

In ROI Terms, Which Choice is the Better Business Decision?

Using simple ROI as the sole decision criterion, which choice, Alpha or Beta, is the better business decision? This equates to asking "Which case has the better returns compared to costs?"

  • Comparing 3-year results from each case, Case Beta's 35.9% ROI is greater Alpha's ROI of –3.1%. As a result, when other factors are equal, Beta is the better business decision for a 3-year investment.
  • Consider 5-year results, Case Beta still has the greater ROI of 51.1%, while Alpha's 5-year ROI is less, at 29.5%. Consequently, when other factors are equal, Beta is also the better business decision when the 5-year investment life is in view.

In brief, the return on investment metric shows a large advantage for Beta, even though Alpha has the greater 5-year net cash flow ($140 vs. $120). Why? Note especially that simple ROI derives from periodic inflows and outflows, not from net cash flows. Comparing cases, Alpha has larger inflows and outflows, while most of Beta's inflows and outflows are smaller. As a result, Alpha brings in greater profits, while Beta is more profitable. Return on investment reveals that difference. NPV, IRR, and Payback metrics are blind to that distinction because they derive from net cash flow figures.

The Difference Between Profits and Profitability Is Important

The differences between profits and profitability can be important for several reasons, which means, therefore, that some analysts consider an ROI figure mandatory for every investment review. Option Alpha may become less attractive in the investor's eyes, for instance, because he or she must first budget and pay for Alpha's larger total costs, no matter how large the incoming returns. As a result, the business decision maker may simply be unwilling or unable to do so.

In Conclusion
When and Where Should You Use ROI?

ROI usage is usually legitimate when the metric can usefully address questions about investments and decisions such as these:

  • Should we make this investment, "Yes" or "No"?
  • Does the investment bring a net gain or a net loss?
  • What is the profitability of this investment? In other words, what is its return on investment?
  • Which of several competing actions is the most profitable? And, which option should we choose?

Also, however, it is important to remember that the metric should be used only when the appropriate cash flow data for calculating the metric are available. This means that ROI is legitimate only when all investment costs (cash outflows) and all returns (cash inflows) are known.

Regarding input data for the metric, therefore, it is helpful to two consider two different situations:

  • Return on investment can evaluate very simple investment situations with only one cash outflow and one cash inflow.
  • More often, however, return on investment applies to investment scenarios with multiple cash inflows and outflows across a longer investment life.

Simple Two-Event ROI Example

For simple action scenarios with only one cash outflow and one cash inflow, ROI data needs are very simple. Here, the analyst needs only two numbers:

  • Cash inflow
  • Cash outflow

As a simple example, consider this question:

What is return on investment for a gambler's winning bet on a horse race?

In this example, just before the race, the bettor places a $10 bet on horse #4 to win. and then, a few minutes later, horse #4 finishes first. The payoff for a winning bet depends of course on the "odds" in effect when betting windows close. The resulting ROI, therefore, also depends on the betting odds and the bettor can say, correctly, that these odds are the same as the ROI for this bet. Suppose in this case the winning bet pays $24. As a result, ROI is 240% for this simple investment.

ROI = (24 - 10) / 10 = 240%

There is one cash outflow (the $10 bet) and one cash inflow (the $24 payoff). Both events are due to the investment, and the ROI meaning is therefore valid. Note especially that the "two-event " metric result does not take into account the time period between outflow and inflow. Remember also that ROI itself is also unconcerned with investment risks or the advisability of making such an investment.

Using the Two-Event ROI Model

The two-event ROI model applies to other simple investment questions such as these:

  • What is the ROI on a non-coupon-paying bond purchase?
  • What is the ROI on a work of art, purchased as an investment?

Note especially that the two-event model assumes there are no important owner costs besides the single purchase cost.

Complex Actions: Multiple Cash Inflows and Outflows over Extended Time Period.

In business, the return on investment metric more often applies to actions that bring many cash flow events across many years. Case Alpha and Case Beta above are examples of the multi-event, multi-year ROI. Here, unlike the simple two-event case, the analyst must therefore know the length of investment life. This is because this life span determines which data go into the ROI ratio.

Calculating Multi-Year Multi-Period ROI

For the multi-event, multi-year case, therefore, all that the analyst needs the following to calculate return on investment.

  • The known length of the investment life.
  • Total investment costs (cash outflows).
  • The sum of returns due to the investment(cash inflows) across investment life.

For Case Alpha, the 5-year inflow sum is $615 and the 5-year outflow sum is $475. As a result, the Case Alpha metric calculates as 29.5%.

ROI = (615 - 475) / 475 = 29.5%

This result is the "5-year ROI" for Case Alpha. Note especially that investment time period is relevant because data were available for other time spans as well, such as 3-year metric. Note also, that even though total investment life span is important, the ROI result for the entire 5-year life is blind to the timing of inflows and outflows within the investment life. This contrasts with other cash flow metrics such as NPV, IRR, and Payback Period, which are indeed sensitive to cash flow timing in the investment life. (See the section below, "How does ROI compare to NPV, IRR, Payback, and other financial metrics?")

Using Multi-Year Multi-Period ROI

In conclusion, multi-year multi-period return on investment figures of this kind can address a very broad range of business questions. For example:

  • What is the ROI for college education?
  • Is there a positive ROI for professional training?
  • Will the marketing program show a positive ROI?
  • What is the ROI for buying a restaurant business?

When and Where to Avoid the ROI Metric

Simple return on investment figures sometimes appear at times when the ROI metric is not really appropriate. Consequently, it is helpful to point out some few common situations where the analyst should refrain from using simple ROI.

Avoid ROI When Cash Inflow and Outflow Figures Are Not Available.

Analysts sometimes approach a cash flow stream starting with "Net cash flow" figures for each period. The Alpha and Beta examples show, however, that net cash flow figures alone do not reveal true profitability (simple ROI) for an investment. To build a proper ROI ratio, therefore, the analyst must uncover the underlying inflows and outflows. Nevertheless, some people, produce ROI figures anyway, using the negative net cash flows as "costs" and the positive net cash flows as "returns." As a result, the meaning of those ROIs is unclear.

Avoid Simple ROI When Comparing Investments for Different Time Periods.

A four-year ROI for one action does not compare properly to a seven-year ROI for another investment. Remember the advice, "Other things being equal, the better choice is the option with the higher ROI." However, when comparing metrics for investments or actions with different time periods, "Other things" are definitely not equal. Consequently, ROIs for different time periods should not be compared.

Avoid ROI When You Do Not Know That Cash Inflow and Outflow figures Are Due to the Investment, Only.

This issue becomes important when using ROI to address questions such as these:

  • What is the return on investment for a marketing program?

    It may be relatively easy to measure costs due exclusively to the program. However, in a situation where gains such as "greater sales" or "increased profits" no doubt result from many actions besides the marketing program, it is therefore difficult to measure the portion of those returns due specifically to the program.
  • Which business case scenario has the better return on investment?

    Business case scenarios typically value future costs and benefits in terms of estimated cash outflows and inflows. When calculating ROI for one or more proposal scenarios, however, the analyst must calculate the metric From incremental cash flow figures. Incremental cash flow is the difference between a proposal scenario's projected cash flows and a baseline scenario's projected cash flows. Incremental values are therefore necessary because these values, alone, measure cost and benefit impacts due only to the action or investment (See the section below, "How is ROI used for evaluating business case scenarios?")

Should You Calculate ROI From Discounted Cash Flow PV Figures?

Some people in business produce ROI metrics from discounted cash flow figure, that is, from inflow and outflow present values (PVs). This approach presents few computational problems because once you have the present value for each cash inflow and outflow, finding the metric itself is as simple as building the metric from non discounted data. Nevertheless, while the ROI math may be simple, interpreting PV-based ROIs can be more difficult. As a result, many businesspeople cannot explain the meaning or proper use of ROI when the metric results from PV figures. Consequently, the PV-based metric appears rarely.

Example Calculation Using Discounted Cash Flow Data

For an example PV-based ROI, consider these cash flow figures for Case Alpha.

 Case
 Alpha

 PV @8%
Cash Inflow Alpha
Inflow PV @8%
Cash Outflow Alpha
Outflow PV
@8
Now 
0
0
-100
-100
Year 1
90
83
-70
-65
Year 2 
100
86
-70
-60
Year 3
125
99
-85
-67
Year 4
145
107
-75
-55
Year 5
155
105
-75
-51
Total  
615
480
-475
-398

 

The present value PV for each inflow and outflow represents end-of-period discounting and a discount rate of 8.0% (see the article Discounted Cash Flow for more on present values). As a results, under the PV-based approach, ROI derives from the sum of the inflow PVs (480) and the sum of the outflow PVs (398). Consequently, the PV-based 5-year return on investment for Case Alpha is 21.1%.

ROIpv = (480 - 398) / 398 = 21.1%

While the result using non discounted cash flow figures is ROI = 29.5%.

Using similar PV figures for Case Beta above, the sum of Beta inflow PVs is 293 and the sum of Beta outflow PVs is 210. As a result, the Case Beta, ROIpv is 39.5%.

ROIpv = (293 - 210) / 398 = 39.5%

While the result using non discounted cash flow figures is ROI= 51.1%.

Discount-Based Metrics vs. Metrics Based on Non Discounted Data

Note especially that both PV-based metrics are lower than the same ROIs based on non-discounted cash flows. Understanding the reasons for these differences, therefore, is key to understanding what PV-based ROI says about investment cash flow streams.

  • The PV-based metric can turn out to be either greater or less than ROI from non discounted figures. This is because the greater discounting impact can fall either on the cash flow costs (outflows) or on the cash flow returns (inflows).
  • In cases where larger costs come early and larger gains come later, discounting lowers ROI. That is because discounting has a greater impact on the later larger gains, while the discounting impact is less for the earlier larger costs.
  • For investments or actions where the larger costs come later and larger gains arrive early, discounting has the opposite effect, that is, discounting raises ROI. That is because, in this case, discounting has a greater impact on the later large costs, while the impact is less for the early larger gains.

Front Loaded vs. Back Loaded Cash Flow Streams

Alpha and Beta both have "investment curve" profiles because, in both cases, larger costs come early and larger returns come later. As a result, both cases have a PV-based ROI that is less than the ROI from non-discounted cash flows. In such cases, the investor can therefore properly say that ROI becomes more conservative, or more pessimistic, when "investment curve" ROIs derive from PV data.

Notice especially, that the size of the discounting impact differs between Alpha and Beta. The discounting impact on Alpha is greater while the discounting impact on Beta is less. Changing to the PV approach reduces Alpha's ROI by 28.5% (from ROI = 29.5% to ROI = 21.1%), while the same change lowers Beta's ROI by 22.7% (from ROI=51.1 to ROI=39.5%).

This difference is due to the back loaded nature of Alpha's cash flow stream, compared to Beta's front loaded cash flow stream. Even though both cash flow streams qualify as "investment curves," note that Alpha's largest cash inflows arrive later in the 5-year investment life), while Beta's larger cash flows arrive earlier in the 5-year life. Alpha's ROI, therefore, suffers a greater discounting impact than Beta. This is because Alpha's later large returns are discounted more heavily than Beta's early returns.

PV-Based ROI Conclusions

An earlier Case Alpha example stated that the "ROI result for the entire investment life is blind to the timing of inflows and outflows within the investment life." Note especially, however, that statement does not apply to PV-based ROI because the size of the discounting effect is indeed sensitive to cash flow timing.

To some analysts, the examples above shows how the PV based approach adds useful information to the ROI figures while to others, the same example shows how PV-data confuse the metric's meaning. And, to many businesspeople the discussion about front loaded and back loaded cash flow streams no doubt seems "theoretical," probably having little practical value for those making real-world investment decisions or for business planning. Therefore, In the interest of clarity and easily understood meaning, many business analysts, investors, and decision makers decide that bringing PV-based cash flow into the ROI picture simply "muddies the waters." Consequently, many prefer to avoid discounted data when using ROI, while leaving time-value-of-money concepts to the metrics meant specifically to handle them: net present value NPV and internal rate of return IRR.

Analysts and decision makers are free, of course, to use or not use PV-based data for ROI, as they wish. However, those who prefer PV-based ROI's should be sure that everyone involved understands how the ROIs are derived and also how to understand the discounting effects.

ROI Results Alongside Other Metrics
Net CF, NPV, Payback, IRR and Growth Rate

Decision makers and investors turn to ROI and other cash flow metrics such as NPV, IRR, and Payback to address questions like these: "What is investment profitability." And, Do the returns justify the costs? And, simply "What do we get back for what we spend?" In other words, they turn to metrics that take an "investment view" of an action or investment.

Note especially that several different financial metrics besides ROI serve this purpose. This means that these metrics compare the timing and sizes of returns to the timing and sizes of costs. Note especially that each of the major investment cash flow metrics (ROI, IRR, NPV, and Payback Period) approaches this task in its own way, and as a result each carries a different message about the nature of the cash flow stream. Also as a result, each of the metrics is blind to certain aspects of the cash flow streams—aspects that other financial metrics do see. And, note also, that the different metrics can disagree on which of the investments is the better business decision.

All of this leads to these conclusions:

  • Important decisions should not be decided with just one financial metric.
  • When different metrics disagree as to which option is the better choice, decision makers must examine the current financial situation to decide which metrics to follow.

Financial Metrics for Alpha and Beta Cash Flow Streams

The different natures of Alpha and Beta results also stand out in the cumulative cash flow graph, below. Cumulative cash flow for a period is the sum of all net cash flows through the end of the period, the fourth data column in the tables above. (For more on cumulative cash flow and payback, see the articles cash flow and payback period.) Note especially that some people refer to 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 represent net cash flow figures, not the cash inflows or cash outflows that make up the net figures.

Which case, Alpha or Beta, is the better business decision? Analysis shows that each case has points in its favor, compared to the other, and decision makers must therefore weigh ROI results along with several other metrics to decide which is best choice for them.

Five Financial metrics to Compare with Return on Investment

When comparing different investment choices, here are some metrics to consider:

Total Net Cash Flow

When comparing cash flow streams like these, the analyst no doubt turns first of all to the financial metric total net cash flow. For a 5-year period, Alpha's cash flow total is greater, at $140, while Beta's cash flow is less, at $120. Hence, Case Alpha outscores Beta on the total net cash flow metric. Therefore, the analyst can say that Alpha has the greater profits.

Future Performance

Future performance is not a financial metric, per se, but while reviewing total net cash flow, the analyst will certainly notice that the two cumulative cash flow curves point to very different results for the years after year five. Notice especially that by Year 5, Alpha's cumulative curve is growing at a rapidly increasing rate while Beta's growth seems to be leveling off. If both investments have no impacts after year 5, of course, there will be no "future performance to consider." However, If the analyst believes these investment patterns will continue, Alpha therefore scores higher than Beta in terms of likely future results.

Simple Return on Investment

Among the financial metrics, the analyst will probably turn secondly to the simple ROI figures for each case. Note especially that Beta's 5-year ROI is higher at 51.1% while Alpha's is less, at 29.5%. Therefore, Beta scores higher than Alpha with the ROI metric. As a result, the analyst may choose to report that Beta scores higher in profitability. The analyst may also note that Beta in fact shows greater profitability at every year end through the 5-year period.

The Payback Period Metric

The curves above show roughly the point in time when cumulative cash flows "break even," that is, when total inflows exactly balance total outflows. This point on the time axis is the payback period for each case. Therefore, payback for Beta is better (i.e. shorter, or less) at 1.5 years, while Alpha's payback is worse (longer, or greater) at 3.14 years. Other things being equal, analysts prefer a shorter payback to a longer period. Why? The two most important reasons are probably these:

  • Analysts prefer the shorter payback period because it means cost expenditures are recovered and ready for use again, sooner.
  • Analysts consider a shorter payback period less risky than a longer payback period.

In terms of payback period, therefore, Case Beta scores higher than Case Alpha.

The Net Present Value NPV Metric

When cash flow returns and costs extend two years or more into the future, almost all analysts will want to compare cash flow streams with the net present value (NPV) metric. Using a 10% discount rate, Beta has the greater net present value (NPV) of $76.18, while Alpha's NPV is less, at $70.51. Consequently, under the time value of money rationale, Case Beta is worth more, today, than Alpha, even though Alpha will return more funds after 5 years. Case Beta therefore outscores case Alpha in terms of the NPV metric.

The Internal Rate of Return Metric

Finally, in some settings, analysts will compare cash flow streams in terms of the internal rate of return metric. Internal rate of return (IRR) is the interest rate that produces an NPV of 0 for a cash flow stream. In reality, not many businesspeople are prepared to explain IRR figures in a way that makes practical sense for decision makers and investors. Nevertheless, financial officers in certain industries (such as financial services or insurance) rely on the metric for decision support. (see the article Internal rate of return for more on IRR, problems with IRR usage, and a recommended alternative, modified internal rate of return MIRR).

Here, Case Alpha has the lower IRR rate, at 28.9% while Beta's IRR is higher at 44.9%. Financial officers usually view an investment with an IRR above their cost of capital as a net gain and, here, both cases show IRR well above any company's cost of capital. However, when proposals compete for funds, and when other factors are equal, decision makers prefer the proposal with the higher IRR. In conclusion, case Beta has the advantage in terms of IRR.

Financial Metrics Comparison Summary

In conclusion, different financial metrics can disagree on which investment is the better business decision. The table below summarizes these differences for this example:

 Financial Metric
Case Alpha
Case Beta
Net Cash Flow 
$140
$120
Return on Investment ROI 
29.5%
51.1%
Future Performance 
Improving
Neutral
Payback Period
3.14 Yr
1.50 Yr
Net Present Value NPV 
$70.51
$76.18
Internal Rate of Return IRR 
29.9%
44.9%

Green cells hold the better outcome for each financial metric.

From the metrics analysis above, which action, Alpha or Beta, is the better business decision? Four of the metrics in the table favor case Beta while two of the metrics favor Case Alpha. In conclusion, there is no "one size fits all" answer, except to say that ROI is one factor decision makers and planners will consider. However, they will probably also consider other factors, and then give different weights to the different metrics. This means they will probably consider such things as:

  • Company business objectives.
  • The current financial situation.
  • Risks with each investment.
  • Other actions that may be available.

Using ROI to Evaluate Business Case Scenarios

Which business case scenario should the analyst recommend? Does the business case justify funding the proposal? ROI and other cash flow metrics (NPV, IRR, and Payback) often play a role in addressing such questions.

The business case looks forward in time, projecting cash inflows (benefits) and cash outflows (costs) under two or more scenarios. First of all, one scenario will certainly represent the proposed action or investment. Secondly, however, cases should also include a "Baseline" or "Business as usual" scenario. Note especially that the Baseline scenario projects results for the same cost and benefit items without taking proposed action. Consequently, the Baseline scenario therefore lets the analyst measure changes (from Baseline) that would follow from taking action.

With two full value scenario cash flow statements (one for the Proposal scenario and another for the Baseline Business as usual), the analyst also builds an incremental cash flow statement. Figures in this statement represent the differences between the same cash flow items in the two full value scenarios, hence the term incremental. As a result, the incremental cash flow values represent only cash flows due to the action or investment. These values are therefore legitimate data for finding scenario ROIs. (For more on business case cash flow scenarios, see the article business case cash flow statement. Also, for ROI examples with business case cash flow, see Business Case Essentials.)

Which Other Metrics Are Also Called Return on Investment ROI?

The return on investment name sometime applies to several other metrics in financial statement analysis—where analysts assess a company's financial health and earnings results. Some people say ROI when referring to metrics also known as:

Return on Capital Employed
Return on Total Assets
Return on Equity
Return on Net worth
Earnings per Share
Average Rate of Return

In addition, the term some people refer to cumulative cash flow results over time as a "return on Investment curve." Also some people refer to still other cash flow metrics as return on investment, such as average rate of return and even internal rate of return.

In conclusion, several different return on investment metrics are commonly used. And, the term itself does not have a single meaning that everyone in business understands in the same way. Therefore, when using return on investment figures, it is good practice to be sure that everyone involved understands exactly which version of the metric iw.