Business Analysts: Stop Using RoI to Evaluate Project Investments

Introduction

Return on Investment (RoI) is one of the most widely used financial metrics for evaluating the effectiveness of an investment. It offers a simple way to compare the returns from various investments, enabling businesses and individuals to make informed decisions. However, despite its popularity, RoI isn’t always the best metric in every situation. In this blog, we’ll explore when RoI is suitable, when it falls short, and what financial ratios might be better suited for certain scenarios.

Understanding RoI: A Brief Overview

RoI is a financial ratio used to measure the gain or loss generated from an investment relative to its cost. It is typically expressed as a percentage and calculated using the following formula:

RoI% = (Net Benefit from Investment - Cost of Investment)*100/Cost of Investment

A positive RoI indicates that the investment has generated a profit, while a negative RoI suggests a loss. This simplicity is what makes RoI so appealing; however, it can oversimplify complex financial decisions.

Why is RoI Not A True RoI Measure

1. RoI is not an annual % number; it is a number provided for the whole investment periods

Typically, RoI is calculated for a period, say 5 years. Let’s take a very simple example of computing RoI and seeing the associated problems.

Organization A is embarking on implementing an​ ERP system. The organization will spend USD 500K on license fees. Cost of implementation is expected to be USD 200K. The organization shall spend 100K per year to maintain the system. The organization expects a benefit of USD 300K per year by implementing the system. The useful life of the project is 5 years.

In this case, the Gain from the system is 300K Per Year * 5 years = 1500 K USD.

Investment = 500K License Fee + 200K Implementation Fee = USD 700K

Maintenance cost = 100K per year * 5 years = 500K

Net Benefit = USD 1500K – USD 700K – USD 500K = USD 300K

RoI% = USD 300K*100/USD 700K = 42%

This number might look very attractive to humans, but we are constantly bombarded with inflation and interest rate numbers, which are typically within 10%. However, both inflation and interest rates are annualized numbers, whereas RoI is NOT an annualized number.

But, please note that this benefit is accrued over a 5-year period. So, if we take annualized RoI, it turns out to be 42%/5, just about 8%.

But if the cost of funds is 10% per annum, then the company is actually losing money.

So, we propose a better RoI formula:

True RoI% = (RoI% / Investment Period) – Annual Rate of Cost of Funds

This will indicate True RoI% received by the business.

2. Economies with high inflation and high interest rate

In a high-inflation economy, companies can’t borrow money at a very low rate. For example, the inflation rate in the USA has reached the level of 5%. Hence, the cost of funds now is more than 12 to 15%, and RoI does not account for inflation adjustment.

3. Long-Term Investments

RoI does not account for the time value of money (TVM). For long-term investments, such as research and development (R&D) projects or infrastructure investments, a higher initial cost might be justified by future returns. RoI does not provide a clear picture of how an investment will pay off over an extended period.

4. Risky Investments

RoI does not consider the risk associated with the investment. Two investments with the same RoI may have vastly different risk profiles, making RoI an inadequate metric when assessing risky investments like startups or speculative ventures.

When RoI falls short, several other financial ratios may provide a clearer picture of an investment’s true value, especially in more complex or long-term scenarios.

Better Financial Ratios

1. Net Present Value (NPV)

NPV is a more comprehensive measure of an investment’s profitability. It accounts for the time value of money by discounting future cash flows back to their present value. NPV is particularly useful for long-term investments with multiple cash flows. A positive NPV indicates that an investment is expected to generate more value than its cost, making it a better tool for project evaluations over time.

2. Internal Rate of Return (IRR)

IRR is the discount rate that makes the NPV of an investment zero. It’s a more advanced metric than RoI, and it considers the timing of cash flows, which RoI does not. IRR is useful for comparing investments of different durations and cash flow patterns, especially in projects with multiple phases.

3. Payback Period

The payback period measures how long it will take for an investment to recover its initial cost. While it doesn’t account for the time value of money like NPV or IRR, it’s useful for assessing the risk of an investment. Shorter payback periods generally indicate less risk, making this ratio effective for cash-strapped businesses or when liquidity is a concern.

4. Profitability Index (PI)

This ratio is the ratio of the present value of future cash flows divided by the initial investment. It’s helpful for comparing projects of different sizes and is especially useful when resources are limited, and there is a need to prioritize which projects to fund.

Conclusion

Return on Investment (RoI) is a popular and valuable metric for evaluating certain types of investments, especially short-term or straightforward projects. However, for long-term or high-risk investments, RoI may not provide the depth and accuracy needed to make well-informed decisions. In these cases, more sophisticated financial ratios like NPV, IRR, and the payback period may offer better insights into the true profitability and risk of an investment. By understanding when to use RoI and when to turn to other financial metrics, businesses can make more effective and informed investment decisions.

When assessing your next investment, don’t settle for the simplicity of RoI alone. Consider the full picture and explore alternative ratios that provide deeper insights into your investment’s long-term value. After all, making sound financial decisions is more than just looking at numbers—it's about understanding the story they tell.