Right now there’s a phone commercial. A guy is building a birdhouse and he says to someone else “I’m thinking of renting it out to get a better return on investment”. Now this guy understands what ROI is. He has an investment. He understands what it means. It’s how much he makes relative to what he put into it.
Investopedia defines ROI as the amount of net income returned as a percentage of shareholder equity. It further amplifies this definition to allow for different organizations to calculate ROI differently. ROI can be a cash amount, it can be a ratio, a percentage, or an annual yield. One thing clearly absent from this list of possible ways to calculate a return on investment is a time period.
I have frequently heard this term misapplied. People say ROI when they mean payback period ( how long an investment takes to return its cost to the investor). These are distinctly different things. An investment can have a great ROI but a long payback period. That makes for a great investment. Conversely, an investment can have a short payback period, but an awful return. Payback period is more of a tool to evaluate financial risk than quantify financial benefit. It lets someone understand how long their capital is at risk. It says nothing of how well the investment pays back it’s owner. It’s actually a rather poor tool to evaluate a project.
So whenever I hear “what’s the ROI?”, a part of me cringes. Because I have to ask myself, “Does this individual mean payback period or are they asking for how profitable of an investment this project is?” Not only should the people asking the question be informed enough to know the difference between payback period and ROI, but also they should be savvy enough to understand that on its own, payback period is a useless metric. But frequently this is not the case.
For color, and investment can that costs $10,000 and returns that in 16 months has a 16 month payback period. But it has no cash flows after that. It’s worthless, it has just tied up you capital, and actually has a negative NPV when cost of capital is not zero (which is the real world).
Let’s look at another investment. It costs $10,000 and returns $2,500 each year for ten years. It has a 48 month payback period, but it is a great investment. Each year it returns 25% of the original investment to the investor. This project would have a NPV (discussed below) of $5,361 and an IRR of 21% (with a 10% cost of capital) as opposed to a negative NPV for the above project with a shorter payback period . Any hedge fund manager would kill for an NPV of $5,300 on a $10,000 investment and would repeat that investment every chance he had. It is a fantastic investment, but it has a longer payback period.
Just looking at payback period, while at the same time calling it ROI, one might think that the far inferior investment was the right one, and they would make a terrible decision. Corporate finance is not unduly challenging, but it does require understanding the key metrics.
Let me take this a little further by providing some great ways to evaluate projects so the awful ways can head to the rubbish can:
Net Present Value (NPV) – this represent the value, in today’s dollars, of all the cash flows for a project for its entire life, including the cost (cash outflow) and the returns. This accounts for the time value of money (something payback period doesn’t even acknowledge exists). This is the best tool for evaluating projects. Taking it a bit further, you can analyze projects NPV versus first cost to maximize your NPV among a portfolio of project options (this is called the profitability index, or PI, and is calculated by dividing the present value of future cash flows by the project cost) if expanding your budget is not an option, however investing common sense would dictate that as long as NPV is positive, you should find a way to fund that project as it adds to shareholder value. NPV is the big dog in analyzing a project or investment, give it the respect it deserves.
Internal Rate of Return (IRR) – this is easily thought of as how fast your investment is growing your money. This plays second fiddle to NPV in well evaluated analysis, but is useful on its own. You can apply hurdle rates for projects based on variance of returns ( high risk project needs a higher IRR to be acceptable) and you can compare projects on IRR. IRR calculation fails when there is a sign change ( if a project has a positive, the a negative, then a positive return) and requires what’s call a modified IRR (MIRR) but that is beyond the scope here. IRR also considers cost of capital ( nobody lends you money for free) the same way as NPV.
Profitability Indexs can help you maximize your return on a pile of money, but investing discipline would tell you that you should do all projects with a positive NPV as cost of capital has been considered, and keep acquiring more capital for projects until the cost of capital increases and reduces the NPV to 0. That’s not how some internal budgets work, so I won’t go to deep into that here. But if you could borrow money at 4% and get a safe return at 6% you should keep borrowing and borrowing until lenders start charging you 6% and you can not make any gains. ( I am not suggesting you buy a bunch of money and stick it in stocks that would be a big risk but addressing that requires a whole other level of discussion revolving around modern portfolio theory).
Getting from very crude analysis of a project to fairly effective is a simple small leap. Net present value is a crucial, fairly simple to use tool to get yourself in the game, so to speak, of actually evaluating a project on its financial merits: How does this benefit the company? What does this do to shareholder value? You can start addressing these seemingly sophisticated questions simply and intelligently.
With just a little work the big, important concepts can be mastered.
Don’t hesitate to ask any questions. Thanks for reading!