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Reprinted from The Triangle TechJournal
Let's face it — all businesses exist for the sole purpose of maximizing shareholder value. And in today's business climate where budgets are tight and competition is tough, it is becoming more and more challenging. It is no surprise that organizations are requiring potential investments be backed by business cases that are centered around quantifiable, reliable, and compelling estimates of Return on Investments (ROI). In a nutshell, ROI is an estimate of the financial benefit (the “Return") on money spent (the “Investment") on a particular alternative (e.g., an IT project). Because a company is foregoing the use of funds for the sake of the investment, the investment must not only return the original capital, but also return enough to compensate for what the funds would have earned elsewhere, plus an allowance for risk.
Simple ROI can be derived by taking the return, or incremental gain, of an investment divided by the cost of that investment. For example, what is the ROI for a new marketing program that is expected to cost $300,000 over the next five years and deliver an additional $500,000 in increased profits during the same time?
Simple ROI works well in situations where both the gains and the costs of the investment are easily known and where they clearly result from the action. Other things being equal, the investment with the higher ROI is the better investment. It is important to note that the return on investment metric says nothing about the risks in the investment.
To help understand how ROI calculations can be of assistance in making decisions, consider this example. You have a dollar to spend (invest) and you have two choices of how to spend it, either of which would cost one dollar. Which should you invest in? The answer to this question another question — what is the return?
Suppose that for your $1 investment in Option A you will gain $0.30, while you gain $0.60 from Option B. Most people would be inclined to view Option B more favorably, since it offers a greater ROI.
But have you considered when you would receive the money. If it takes 20 years to get the $1.60 from Option B and 1 year to get the $1.30 from Option A, you might conclude that the payback period for Option B is too long and decide to go with Option A.
In complex business settings, simple ROI becomes less trustworthy as a useful metric and you should consider more encompassing ROI models. Three of the most frequently used models include: the payback model, the accounting rate-of-return model, and the net present value model.
The payback model is the simplest way of looking at one or more investment ideas. It defines the time required to recover the original cost of the investment through a formula that divides the cost of the investment by its annual cash inflows. Under the payback model, investments with shorter payback periods rank higher than those with longer paybacks. The theory is that investments with shorter payback periods are more liquid and thus, less risky. Generally, a payback period of three years or less is preferred. The two major drawbacks of the payback model are that it ignores the time value of money and does not consider benefits that occur after the payback period.
The accounting-rate-of-return (ARR) model can give you a quick estimate of an investment's net profits, and can provide a basis for comparing several different investment options. The return on investment by this model is calculated by dividing annual cash inflows less depreciation by the cost of the initial investment. Under this model, returns for the investment's entire useful life are considered. However, the ARR model uses income data rather than cash flow, and it also ignores the time value of money.
The net present value (NPV) model of evaluating a major investment allows you to consider the time value of money. Essentially, it helps you find the present value in “today's dollars" of the future net cash flow of an investment. If the NPV is greater than the cost, then the investment will be profitable for you. If you have more than one option to choose from, then you can compute the NPV of all and select the one with the greatest difference between NPV and cost. The easiest way to compute the NPV of an investment is to use a financial calculator.
Beyond the financial metrics, the smartest companies are measuring a complex mix of business objectives, costs, and risks. Initiatives are being categorized by specific corporate goals — such as raising the stock price, increasing market share, or lowering operating costs — then evaluated with historical and other data to quantify potential returns.
At the end of the day, ROI is no different than any other quantitative analysis tool — e.g. stock price forecasting, synergy analysis, market forecast, etc. These metrics provide powerful tools for putting a framework around a potential opportunity and enabling organizations to make better investment decisions.