Return on investment

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Return on investment (ROI) is a ratio between net income (over a period) and investment (costs resulting from an investment of some resources at a point in time). A high ROI means the investment's gains compare favourably to its cost. As a performance measure, ROI is used to evaluate the efficiency of an investment or to compare the efficiencies of several different investments. [1] In economic terms, it is one way of relating profits to capital invested.

Contents

Purpose

In business, the purpose of the return on investment (ROI) metric is to measure, per period, rates of return on money invested in an economic entity in order to decide whether or not to undertake an investment. It is also used as an indicator to compare different investments within a portfolio. The investment with the largest ROI is usually prioritized, even though the spread of ROI over the time period of an investment should also be taken into account. Recently, the concept has also been applied to scientific funding agencies’ (e.g., National Science Foundation) investments in research of open source hardware and subsequent returns for direct digital replication. [2]

ROI and related metrics provide a snapshot of profitability, adjusted for the size of the investment assets tied up in the enterprise. ROI is often compared to expected (or required) rates of return on money invested. ROI is not time-adjusted (unlike e.g. net present value): most textbooks describe it with a "Year 0" investment and two to three years' income.

Marketing decisions have an obvious potential connection to the numerator of ROI (profits), but these same decisions often influence assets’ usage and capital requirements (for example, receivables and inventories). Marketers should understand the position of their company and the returns expected. [3] For a marketing ROI percentage to be credible, the effects of the marketing program must be isolated from other influences when reported to executives. [4] In a survey of nearly 200 senior marketing managers, 77 percent responded that they found the "return on investment" metric very useful. [3]

Return on investment may be extended to terms other than financial gain. For example, social return on investment (SROI) is a principles-based method for measuring extra-financial value (i.e., environmental and social value not currently reflected in conventional financial accounts) relative to resources invested. It can be used by any entity to evaluate the impact on stakeholders, identify ways to improve performance and enhance the performance of investments.

Limitations with ROI usage

As a decision tool, it is simple to understand. The simplicity of the formula allows users to freely choose variables, e.g., length of the calculation time, whether overhead cost is included, or which factors are used to calculate income or cost components. The use of ROI as an indicator for prioritizing investment projects alone can be misleading since usually the ROI figure is not accompanied by an explanation of its make-up.[ citation needed ] ROI should be accompanied by the underlying data that forms the inputs, this is often in the format of a business case. For long-term investments, the need for a Net Present Value adjustment is great and without it the ROI is incorrect. Similar to discounted cash flow, a Discounted ROI should be used instead. One limitation associated with the traditional ROI calculation is that it does not fully "capture the short-term or long-term importance, value, or risks associated with natural and social capital", [5] because it does not account for the environmental, social, and governance performance of an organization. Without a metric for measuring the short- and long-term environmental, social and governance performance of a firm, decision makers are planning for the future without considering the extent of the impacts associated with their decisions. One or more separate measures, aligned with relevant compliance functions, are frequently provided for this purpose.

Calculation

Return on investment can be calculated in different ways depending on the goal and application. The most comprehensive formula is:

Return on investment (%) = (current value of investment if not exited yet or sold price of investment if exited + income from investment − initial investment and other expenses) / initial investment and other expenses x 100%.

Example with a share of stock: You bought 1 share of stock for US$100 and paid a buying commission of US$5. Then over a year you received US$4 of dividends and sold the share 1 year after you bought it for US$200 paying a US$5 selling commission.

Your ROI is the following:

ROI = (200 + 4 - 100 - 5 - 5) / (100 + 5 + 5) x 100% = 85.45%

As the duration of this investment is 1 year, this ROI is annual.

For a single-period review, divide the return (net profit) by the resources that were committed (investment): [3]

return on investment = Net income / Investment
where:
Net income = gross profit − expenses.
investment = stock + market outstanding[ when defined as? ] + claims.

or

return on investment = (gain from investment − cost of investment) / cost of investment [1]

or

return on investment = (revenue − cost of goods sold) / cost of goods sold

or

return on investment = (net program benefits / program costs) x 100 [6]

Property

Complications in calculating ROI can arise when real property is refinanced, or a second mortgage is taken out. Interest on a second, or refinanced, loan may increase, and loan fees may be charged, both of which can reduce the ROI, when the new numbers are used in the ROI equation. There may also be an increase in maintenance costs and property taxes, and an increase in utility rates if the owner of a residential rental or commercial property pays these expenses.

Complex calculations may also be required for property bought with an adjustable rate mortgage (ARM) with a variable escalating rate charged annually through the duration of the loan.

Marketing investment

Marketing not only influences net profits but also can affect investment levels too. New plants and equipment, inventories, and accounts receivable are three of the main categories of investments that can be affected by marketing decisions. [3]

RoA, RoNA, RoC, and RoIC, in particular, are similar measures with variations on how 'investment' is defined. [3]

ROI is a popular metric for heads of marketing because of marketing budget allocation. Return on Investment helps identify marketing mix activities that should continue to be funded and which should be cut.

Return on integration (ROInt)

To address the lack of integration of the short and long term importance, value and risks associated with natural and social capital into the traditional ROI calculation, companies are valuing their environmental, social and governance (ESG) performance through an integrated management approach to reporting that expands ROI to Return on Integration. [5] This allows companies to value their investments not just for their financial return but also the long term environmental and social return of their investments. By highlighting environmental, social and governance performance in reporting, decision makers have the opportunity to identify new areas for value creation that are not revealed through traditional financial reporting. [7] The social cost of carbon is one value that can be incorporated into Return on Integration calculations to encompass the damage to society from greenhouse gas emissions that result from an investment. This is an integrated approach to reporting that supports Integrated Bottom Line (IBL) decision making, which takes triple bottom line (TBL) a step further and combines financial, environmental and social performance reporting into one balance sheet. This approach provides decision makers with the insight to identify opportunities for value creation that promote growth and change within an organization. [8]

See also

Related Research Articles

The discounted cash flow (DCF) analysis, in finance, is a method used to value a security, project, company, or asset, that incorporates the time value of money. Discounted cash flow analysis is widely used in investment finance, real estate development, corporate financial management, and patent valuation. Used in industry as early as the 1700s or 1800s, it was widely discussed in financial economics in the 1960s, and U.S. courts began employing the concept in the 1980s and 1990s.

The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the annual effective discount rate. NPV accounts for the time value of money. It provides a method for evaluating and comparing capital projects or financial products with cash flows spread over time, as in loans, investments, payouts from insurance contracts plus many other applications.

Internal rate of return (IRR) is a method of quantifying the merits of a project or investment opportunity. The calculation is termed internal because it depends only on the cash flows of the investment being analyzed and excludes external factors, such as returns available elsewhere, the risk-free rate, inflation, the cost of capital, or financial risk.

Investment is traditionally defined as the "commitment of resources to achieve later benefits". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broader viewpoint, an investment can be defined as "to tailor the pattern of expenditure and receipt of resources to optimise the desirable patterns of these flows". When expenditures and receipts are defined in terms of money, then the net monetary receipt in a time period is termed cash flow, while money received in a series of several time periods is termed a cash flow stream.

This aims to be a complete article list of economics topics:

<span class="mw-page-title-main">Economic value added</span> Value of a firms profit after deduction of capital costs

In accounting, as part of financial statements analysis, economic value added is an estimate of a firm's economic profit, or the value created in excess of the required return of the company's shareholders. EVA is the net profit less the capital charge ($) for raising the firm's capital. The idea is that value is created when the return on the firm's economic capital employed exceeds the cost of that capital. This amount can be determined by making adjustments to GAAP accounting. There are potentially over 160 adjustments but in practice, only several key ones are made, depending on the company and its industry.

In marketing, customer lifetime value, lifetime customer value (LCV), or life-time value (LTV) is a prognostication of the net profit contributed to the whole future relationship with a customer. The prediction model can have varying levels of sophistication and accuracy, ranging from a crude heuristic to the use of complex predictive analytics techniques.

Return on capital (ROC), or return on invested capital (ROIC), is a ratio used in finance, valuation and accounting, as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested by shareholders and other debtholders. It indicates how effective a company is at turning capital into profits.

<span class="mw-page-title-main">Net income</span> Measure of the profitability of a business venture

In business and accounting, net income is an entity's income minus cost of goods sold, expenses, depreciation and amortization, interest, and taxes for an accounting period.

In business, operating margin—also known as operating income margin, operating profit margin, EBIT margin and return on sales (ROS)—is the ratio of operating income to net sales, usually expressed in percent.

The return on equity (ROE) is a measure of the profitability of a business in relation to its equity; where:

Social return on investment (SROI) is a principles-based method for measuring extra-financial value. It can be used by any entity to evaluate impact on stakeholders, identify ways to improve performance, and enhance the performance of investments.

Capitalization rate is a real estate valuation measure used to compare different real estate investments. Although there are many variations, the cap rate is generally calculated as the ratio between the annual rental income produced by a real estate asset to its current market value. Most variations depend on the definition of the annual rental income and whether it is gross or net of annual costs, and whether the annual rental income is the actual amount received, or the potential rental income that could be received if the asset was optimally rented.

In finance, return is a profit on an investment. It comprises any change in value of the investment, and/or cash flows which the investor receives from that investment over a specified time period, such as interest payments, coupons, cash dividends and stock dividends. It may be measured either in absolute terms or as a percentage of the amount invested. The latter is also called the holding period return.

<span class="mw-page-title-main">Real estate investing</span> Buying and selling real estate for profit

Real estate investing involves the purchase, management and sale or rental of real estate for profit. Someone who actively or passively invests in real estate is called a real estate entrepreneur or a real estate investor. Some investors actively develop, improve or renovate properties to make more money from them.

The following outline is provided as an overview of and topical guide to finance:

Return on marketing investment (ROMI) is the contribution to profit attributable to marketing, divided by the marketing 'invested' or risked. ROMI is not like the other 'return-on-investment' (ROI) metrics because marketing is not the same kind of investment. Instead of money that is 'tied' up in plants and inventories, marketing funds are typically 'risked'. Marketing spending is typically expensed in the current period.

In bookkeeping, accounting, and financial accounting, net sales are operating revenues earned by a company for selling its products or rendering its services. Also referred to as revenue, they are reported directly on the income statement as Sales or Net sales.

Human Resource (HR) metrics are measurements used to determine the value and effectiveness of HR initiatives, typically including such areas as turnover, training, return on human capital, costs of labor, and expenses per employee.

<span class="mw-page-title-main">Financial ratio</span> Numerical value to determine the financial condition of a company

A financial ratio or accounting ratio states the relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

References

  1. 1 2 "Return On Investment – ROI", Investopedia as accessed 8 January 2013
  2. ↑ Pearce, J. M. (2016). "Return on investment for open source scientific hardware development" (PDF). Science and Public Policy. 43 (2): 192–195. doi: 10.1093/scipol/scv034 .
  3. 1 2 3 4 5 Farris, Paul W.; Neil T. Bendle; Phillip E. Pfeifer; David J. Reibstein (2010). Marketing Metrics: The Definitive Guide to Measuring Marketing Performance. Upper Saddle River, New Jersey: Pearson Education, Inc. ISBN   0137058292. The Marketing Accountability Standards Board (MASB) endorses the definitions, purposes, and constructs of classes of measures that appear in Marketing Metrics as part of its ongoing Common Language in Marketing Project.
  4. ↑ Phillips, Jack J., Frank Q. Fu, Patricia Pulliam Phillips, and Hong Yi. (2020) ROI in Marketing: The design thinking approach to measure, prove, and improve the value of marketing. McGraw-Hill Publishing. Page 178.
  5. 1 2 Sroufe, Robert (2018). Integrated Management: How Sustainability Creates Value for Any Business. Emerald Publishing. p. 268.
  6. ↑ Phillips, Patricia Pulliam, Jack J. Phillips, Gina Paone, and Cyndi Huff Gaudet. (2019) Value for Money: How to show the value for money for all types of projects and programs in governments, nongovernmental organizations, nonprofits, and businesses. John Wiley and Sons Publishing. Page 335. (
  7. ↑ Eccles, Robert; Krzus, Michael (2010). One Report: Integrated Reporting for a Sustainable Strategy . Wiley. ISBN   9780470587515.
  8. ↑ Sroufe, Robert (July 2017). "Integration and Organizational Change Towards Sustainability." Journal of Cleaner Production". Journal of Cleaner Production. 162: 315–329. doi:10.1016/j.jclepro.2017.05.180 – via Research Gate.
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