What’s the importance of return on investment in business? How can you determine if a business is a good investment?
Perhaps the most basic question anyone who invests in a business asks is, “Will this be a good use of my time and money?” To put it simply, the return on investment (ROI) answers this by measuring how profitable an investment is compared to its cost.
Let’s look at how to calculate ROI and how to read the numbers you get back.
Return on Investment in Business
Karen Berman and Joe Knight discuss how ROI calculations involve estimating future business performance, whether an investment will earn back its value, and what the minimum return must be in order for a business or an investment to move forward.
To calculate a return on investment in business, you estimate the initial cash outlay for a business project and project its future cash flows. According to Berman and Knight, the hard part is to make realistic estimates of how much cash your business will generate, not just theoretical profits. Since determining a return on investment involves making guesses as to future performance, calculating the ROI requires significant judgment and estimation, making it as much an art as a science. However, ROI calculations are useful beyond measuring the performance of your business as a whole—they can also be applied to any new project or venture you create within the larger organization, such as investing in a new product or service.
(Shortform note: Though the process of estimating income is still tricky, AI tools can significantly enhance predictions of future revenue by applying machine learning to historical information, market changes, and customer profiles. By spotting patterns in sales transactions, AI tools can give a comprehensive view of your performance in the market and more accurate forecasts of your future cash flow. Since AI’s real-time processing can adjust your revenue projections on the fly, you can update your ROI calculations as market conditions change, rather than relying on old information. Nevertheless, Berman and Knight might suggest you try to understand the numbers for yourself so that you can filter an AI’s predictions through your personal judgment.)
When calculating your return on investment, it’s also common to take into account how quickly your investment will pay off. The simplest way to do this is to calculate how long it will take for an investment to recoup its initial costs. While easy to understand, this approach has limitations, since it doesn’t consider how money’s value changes over time or what happens after the payback period. Berman and Knight prefer a calculation method called net present value (NPV), which is more complex but provides a more comprehensive analysis. In short, the NPV takes into account that due to inflation, money in the future is worth less than the same amount of money today.
| The Trouble With ROI Because, as Berman and Knight reiterate, there are so many guesses in making revenue predictions, ROI calculations are often inaccurate due to estimation errors. One study suggests that even small mistakes in predicting costs and revenue can lead to substantial errors in the final ROI figure. The study found that in many IT system projects, cost estimation errors typically fell between 30% and 50%. The level of these mistakes can result in highly inaccurate ROI calculations, followed by misguided investment decisions. The study’s author recommends always including an assessment of ROI accuracy alongside your ROI figures themselves to provide a more complete picture for decision-makers. Though Berman and Knight prefer using NPV to calculate ROI, even that approach has disadvantages. First, it requires you to estimate future inflation—what financial experts call the discount rate—which NPV analysis assumes will remain constant. However, inflation rates vary widely as economic conditions change. NPV also doesn’t account for the cost of the investments you might miss at a later date by choosing one now based on NPV analysis. As with nearly all financial decisions, investment potential relies as much on judgment and experience as it does on running the numbers. |
To determine if your ROI is high enough, Berman and Knight say you have to decide on your required rate of return. This is the bare minimum amount of return that your business or a shareholder expects to earn back from an investment for it to be worthwhile. Companies set this rate based on factors such as how much risk is involved and what the potential returns are from other potential investments. If a business or a project’s projected rate of return exceeds this benchmark, it’s considered financially attractive. The rate may vary for different industries or economic conditions, reflecting investors’ tolerance for risk and what your financial goals are.
(Shortform note: For a business owner, the rate of return that Berman and Knight describe will let you decide whether a project or expansion is worth your company’s time and money. For investors looking to buy into your business, the rate of return will manifest as growing stock prices and increasing dividends. In The Intelligent Investor, Benjamin Graham divides these prospective investors into defensive and aggressive. Defensive investors are mostly content to keep up with regular stock market growth, but aggressive investors—those looking to get the best returns on their money—usually expect gains of 5% or more in addition to the stock market’s regular growth. Whether such expectations are realistic is a subject for debate.)
