Return on investment, or ROI, is a term you often here in the corporate world. ROI is not an actual financial metric, like ROA (Return on Assets). When you are talking about ROI, you want to know how much you will get back if you invest in something.
If an athlete invests a lot of time in the gym he will most likely perform better in his sport, which is the return. It’s the same with business. Companies invest in a new product, piece of equipment or project only if they expect a good ROI.
They spend cash they have now in hopes of realizing a return at some future date.
Sometimes managers have to fight with competing projects to receive funding for their project. If they can forecast a good ROI it will help them get the funding.
To determine ROI, you need to understand the time value of money. Over time the value of a dollar one year from now will be less than it is today. Three concepts used in analyzing investments are future value, present value, and required rate of return.
Future value is what a given amount of cash will be worth in the future if it is loaned out or invested. Being able to predict the future value, especially for security investors, is crucial. It can tell you whether your investment is a good one. If a stock is selling for $200.00 and is estimated to increase 20% over the next year, the future value of the stock in one year would be $240.00
Present value is the opposite of future value. If the future value is worth $240.00 in 1 year with a 20% interest rate or increase, then the current value is $200.00
Required Rate of Return
If an investments value expects to increase 20% in three years, the increase percentage is rate of return. Before making an investment decision, investors will have determined a required rate of return. Say if a rate of return is only 3% over the next three years the decision might be to not make the investment.
The fancy term investors use when putting a value on a company is DCF (discounted cash flow analysis). For now, let’s look at the three popular methods for calculating ROI. These can be used to forecast a projects ROI. They are the Payback Method, Net Present Value method, and the Internal Rate of return method. The payback method is a simple calculation to determine how long it will take to get back the original investment. The Net Present Value method is more complicated but also more powerful because if factors in the time value of money. Net Present Value is the present value minus the initial cash outlay. The Internal Rate of Return (IRR) method is like except it calculates the actual return provided by projected cash flows.
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