The funny thing about ROI

Is return on investment (ROI) of 5 a good one?

Are you coming across questions like these? I do too and I’m usually puzzled since this question is loaded with so many assumptions. Let’s identify these assumptions before answering this question.

First, it needs to be clarified what “R” and “I” stand for. ROI is a relative metric and is usually defined as the ratio of returns divided by investments. For a business owner or company shareholder “returns” is the bottom line impact, i.e., revenues minus cost of sales minus all expenses. It’s not only revenues as sometimes “R” is incorrectly defined. In the accounting world, this bottom line impact is called net income or net profit, but for a financial analysis the proper metric should be cash in-flow (more on cash flow in one of the next posts). Definition of “I” is usually less prone to misinterpretation. Investments are simply defined as the expenses required for the investment. And to compare cash flows with cash flows, these expenses should be expressed as cash out-flows.

Second, ROI calculation needs to be based on incremental cash flows. Since the ROI metric is calculated for a particular investment, all data used in the ROI calculation needs to relate only to that investment and not to any on-going business or other investments.

Third, future cash flows need to be discounted. A dollar today is worth more than a dollar tomorrow. Hence, cash flows expected in the future need to be discounted in order to make them comparable with cash flows today. This is addressed by calculating the present value of returns and investments and only then dividing them to calculate ROI.

Fourth, ROI of one investment needs to be compared with ROIs of investment alternatives. A company has usually several choices on where to invest its resources. And each company has usually some history of investment returns. One company in one industry may have historic ROIs in the range of 2-5. Another company in another industry may have historic ROIs in the range of 5-10. Only comparing all investment alternatives together with historic ROIs can lead to sound investment decisions when dealing with relative metrics (more on relative vs. absolute metrics in one of the next posts).

So, if “R” in ROI represents the incremental profit expected from incremental investments, if “R” and “I” are calculated as discounted cash flows, and if other investment alternatives currently available have lower ROIs, then, and only then, is ROI of 5 a good one.

1 comment to The funny thing about ROI

  • [...] The profitability index, also known as benefit-cost ratio, is defined as the present value of future cash flows divided by the initial investment. The profitability index rule is to accept any investment project with an index greater than one. Profitability index most closely resembles net present value. When some people refer to return on investment (ROI) as a metric, they basically mean the profitability index, assuming of course that the ROI calculation is done correctly as described in one of the previous posts. [...]