Return on investment

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Return on investment (ROI) is a ratio between net profit (over a period) and cost of investment (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] 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.

Risk 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. To use ROI as an indicator for prioritizing investment projects is risky since usually the ROI figure is not accompanied by an explanation of its make-up.[ citation needed ] [4] For long-term investments, the need for a Net Present Value adjustment is great. [5] Similar to Discounted Cash Flow, a Discounted ROI should be used instead. One of greatest risks 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" [6] 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.

Calculation

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

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] According to a recent study, business partnerships with "micro-influencers" can bring a greater ROI than collaborations with big celebrities. [7]

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.

Spread Fees Protocol (SFP) (Crypto Currency Based ROI)

First introduced by blockchain platform Radium Core, the Spread Fees Protocol is a new approach to the classic Proof of Stake architecture for receiving a network reward in exchange for securing the network. Blockchain networks are maintained by many different individuals and each of these nodes deserves a little extra reward whenever someone records new data into the SmartChain. Historically, transaction fees were included as a reward in the block in which the transactions resided. The SFP dictates that this could be unfair, as wallets with more coins would be more likely to receive these blocks with higher rewards.  With the spread fee protocol, fees are awarded back to the stakers slowly, over the subsequent 1440 blocks rather than all at once, ensuring that no one powerful staker can capture all the rewards. Most blocks that are staked will have a reward slightly higher than the stated block reward, which is a result of this protocol. The more the network is used, and as more transactions are sent, the extra rewards from spread fees will increase proportionally.

Product Development ROI

In order to evaluate and predict the return on investment, five key numbers are needed [8] :

  1. Average sell price of the finished product
  2. The expected cost involved in developing the product
  3. The profit margin desired
  4. The total cost of the project (which will include prototyping costs, marketing, research, etc.)
  5. Sales forecast - how many products are realistically able to be sold at the average sell price within a fixed period (i.e. one year)

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. [9] 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. [10] 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. [11]

See also

Related Research Articles

In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. Discounted cash flow analysis is widely used in investment finance, real estate development, corporate financial management and patent valuation. It was used in industry as early as the 1700s or 1800s, widely discussed in financial economics in the 1960s, and became widely used in U.S. courts in the 1980s and 1990s.

The internal rate of return (IRR) is a measure of an investment’s rate of return. The term internal refers to the fact that the calculation excludes external factors, such as the risk-free rate, inflation, the cost of capital, or various financial risks.

To invest is to allocate money in the expectation of some benefit in the future.

Economic value added

In corporate finance, as part of fundamental analysis, economic value added (EVA) 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. EVA is a service mark of Stern Value Management.

Earnings before interest, taxes, depreciation, and amortization accounting measure: net earnings, before interest expenses, taxes, depreciation, and amortization are subtracted

A company's earnings before interest, taxes, depreciation, and amortization is an accounting measure calculated using a company's earnings, before interest expenses, taxes, depreciation, and amortization are subtracted, as a proxy for a company's current operating profitability.

In marketing, customer lifetime value, lifetime customer value (LCV), or life-time value (LTV) is a prediction of the net profit attributed to the entire 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.

In economics and accounting, the cost of capital is the cost of a company's funds, or, from an investor's point of view "the required rate of return on a portfolio company's existing securities". It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

Enterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value of a business. It is a sum of claims by all claimants: creditors and shareholders. Enterprise value is one of the fundamental metrics used in business valuation, financial modeling, accounting, portfolio analysis, and risk analysis.

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.

The return on equity (ROE) is a measure of the profitability of a business in relation to the equity. Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on assets minus liabilities. ROE measures how many dollars of profit are generated for each dollar of shareholder's equity. ROE is a metric of how well the company utilizes its equity to generate profits.

Capital budgeting Planning process used to assess an organizations long term investments

Capital budgeting, and investment appraisal, is the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure. It is the process of allocating resources for major capital, or investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.

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.

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 the investment, such as interest payments or 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.

Payback period

Payback period in capital budgeting refers to the time required to recoup the funds expended in an investment, or to reach the break-even point. For example, a $1000 investment made at the start of year 1 which returned $500 at the end of year 1 and year 2 respectively would have a two-year payback period. Payback period is usually expressed in years. Starting from investment year by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1. Then Cumulative Cash Flow = Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year.

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.

The social cost of carbon (SCC) is the marginal cost of the impacts caused by emitting one extra tonne of greenhouse gas at any point in time, inclusive of ‘non-market’ impacts on the environment and human health. The purpose of putting a price on a ton of emitted CO
2
is to aid policymakers or other decisonmakers in evaluating whether a policy designed to curb climate change is justified. An intuitive way of looking at this is as follows: if the price of carbon is $50 per tonne in 2030, and we currently have a technology that can reduce emissions by 1 million metric tonnes in 2030, then any investment amount below $50 million minus interests would make economic sense, while any amount over that would lead us to consider investing the money somewhere else, and paying to reduce emissions in 2030.

IT Application Portfolio Management (APM) is a practice that has emerged in mid to large-size information technology (IT) organizations since the mid-1990s. Application Portfolio Management attempts to use the lessons of financial portfolio management to justify and measure the financial benefits of each application in comparison to the costs of the application's maintenance and operations.

Blended value

Blended Value refers to an emerging conceptual framework in which non-profit organizations, businesses, and investments are evaluated based on their ability to generate a blend of financial, social, and environmental value. The term is usually attributed to Jed Emerson, and sometimes used interchangeably with triple bottom line. Blended value propositions are founded on the notion that value cannot be bifurcated, and is inherently made up more than one measurement of performance. For example, under a blended value proposition, a for-profit businesses would consider their social and environmental impact on society alongside their financial performance measurement. Within the same context, non-profits would consider their financial efficiency and sustainability in tandem with their social and environmental performance. Blended value suggests the true measure of any organization is in its ability to holistically perform in all 3 areas.

Financial ratio characteristic number

A financial ratio or accounting ratio is a 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.

The return on brand (ROB) is an indicator used to measure brand management performance. It is an indicator of the effectiveness of brand use in terms of generating net income. In fact, it is a special case of return on assets (ROA).

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. "how to make money with bitcoin".
  5. Books about long-term investment
  6. Sroufe, Robert (2018). Integrated Management: How Sustainability Creates Value for Any Business. Emerald Publishing. p. 268.
  7. Chidiadi, M. (2017, Mar). Influencer marketing on social media: Influencer marketing on social media: How to find the right influencer & measure your ROI. The Guardian.Retrieved from https://guardian.ng/business-services/influencer-marketing-on-social-media-how-to-find-the-right-influencer-measure-your-roi/
  8. Pallister, B (2020-04-24). "Understanding Your Product Development's Return on Investment". Innovolo Ltd. Retrieved 2020-05-11.
  9. Sroufe, Robert (2018). Integrated Management: How Sustainability Creates Value for Any Business. Emerald Publishing. p. 268.
  10. Eccles, Robert; Krzus, Michael (2010). One Report: Integrated Reporting for a Sustainable Strategy. Wiley.
  11. 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.