Return On Investment (ROI)

Return on Investment (ROI) is a traditional financial measure similar to Return on Equity (ROE) that is used to measure corporation's profitability that reveals how much profit a company generates with the money and other sources from investors.

Return on Investment is based on historic data.  It is a backward-looking metric that yields no insights into how to improve business results in the future.

It is the ratio of money gained or lost on an investment relative to the amount of money invested.

How is the Return on Investment ROI ratio used?

It is used as a general indication of the company's efficiency; in other words, how much profit the company is able to generate given the resources provided by its investors.

Investors usually look for companies with Returns on Investment that are high and growing.

Decision makers often look for ways to improve ROI by reducing costs, increasing gains, or accelerating gains.

It is also a measure of how well a company used reinvested earnings to generate additional earnings.

Return on Investment (ROI) in Investments

In case of stocks, Return on Investment (ROI) is the annual return you would expect to receive on an investment.

ROI, when talking about stocks, is composed of two parts:

• income
• capital gains

In case of stocks, income is the dividend, which is usually paid each quarter. The income return, known as the dividend yield, is simply the sum of dividends for the year divided by the stock price.

The return from capital gains is the percentage gain in the stock price each year. These capital gains have historically accounted for most of the ROI.

In the last half century, stocks have provided ROI of 13%. Dividend yields have averaged about 3% and capital gains have averaged about 10%.

Formula for the Return on Investment metric

                             Net Income
Return on Investment = -----------------------
                         Book Value of Assets

What are the Return on Investment ROI values?

ROI is expressed as a percentage. The higher the ratio, the more efficient the company was in utilizing invested capital.

S&P 500 companies exhibit ROI at around 8%.

Disadvantages of the Return on Investment ROI ratio?

Easily manipulated

The calculation of Return on Investment can be easily modified based on the analysis objective. It depends on what we include in revenues and costs.

On the other hand, a financial analyst would more likely divide the net income of an investment by the total value of all resources that have been employed to make and sell products.

As you can see, each person having different point of view would calculate ROI differently. The ROI result can be expressed in many different ways, so when using this metric, it is important to understand what inputs are being used.

ROI is sensitive to leverage

Assuming that proceeds from debt financing can be invested at a return greater than the borrowing rate, ROI will increase with greater amounts of leverage.

Overstatement

The degree to which Return On Investment (ROI) overstates the underlying economic value depends on several factors:

1. Depreciation: Depreciation rates faster than straight-line basis will result in a lower net income and therefore also in a lower ROI.
2. Growth rate of new investment: Faster growing companies will have lower Return On Investment because they need more equity.
3. Length of project life: The longer lifespan a project has, the more likely the ROI is going to be overstated.
4. Capitalization policy: The smaller the fraction of total investment is capitalized in the books, the greater will be the overstatement of ROI.
5. Lag between investment outlays and their recoupment: The longer it takes to recoup profits, the greater the degree of overstatement.

Now let us take a look at another way to calculate ROI.

Alternative calculation

In some cases the Return on Investment (ROI) may be calculated using the following formula:

                         Net Income + Interest(1 - Tax Rate)
Return on Investment = --------------------------------------
                                  Book Value of Assets

Net Income is increased by interest after taxes. This measure is more accurate because companies can have a lot of cash that earns interest.

Is there any other ratio related to this?

Yes, finance practicioners use other ratios when they analyze financial health of companies. For example the following:

Return On Assets (ROA),

Return on Equity (ROE),

Free Cash Flow (FCF),

Quick Ratio (QuR),

Price Earnings Ratio (P/E Ratio),

or the Cash Asset Ratio (CAR).