Return On Investment
In this study, return on investment (ROI) on marketing and return on investment on finance
would be evaluated according to their components and application areas. After explaining the
components of financial return on investment and marketing return on investment separetely,
we would try to find the similarities and differences between them.
After identifiying the similarities and differences between financial ROI and marketing ROI,
the applications of financial and marketing ROI in Turkey would be investigated by
distributing questionnaries to 200 companies in Turkish market.
As return on investment has a special place in the history of finance for years, the role of ROI
in finance area would be explained first. The financial ROI concept has many applications
ranging from valuation of individual projects to estimation of the return or performance of a
business unit or corporation.
The role on ROI in the valuation of investment projects will be described in the first step.
Standard ROI
Return on investment of a project means the return (incremental gain) from an action
(investment) divided by the cost of that action from a standard point of view. By using this
definition standard equation of ROI can be derived.
ROI = Net Benefits (Gains – Investment Costs)
Costs (Investment Costs)
Term Definition:
Net Benefits (Gains) = Benefits (gains) – (investment) costs
Costs
= (Initial investment) costs
Time Period
= Standard ROI equation is usually calculated for the first year of the
investment. This equation does not take into the consideration the time-value of money. Timevalue of money concept states that a dollar today is worth more than a dollar tomorrow.
The net benefits in the ROI equation can be calculated before or after taxes and depreciation.
Other things being equal, the investment with the higher ROI rate is evaluated as the better
investment. The return on investment itself, however, says nothing about the magnitude of
returns in the investment.
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In addition, the risk of the project needs to be counted, as the value of the project requires to
be discounted to incorporate all the possible financial outcomes associated with the
investment.
In order to consider other investment alternatives and the effect of inflation from a
macroeconomic perspective, time-value of money should be taken into account. As the
magnitude and timing of expected gains to the investment costs does not included in the
estimation, standard ROI calculation might not be applicable across complex business
settings. However, standard ROI can give a first estimate of the benefits of a project.
Net Present Value
Standard ROI calculations do not indicate the time to returns. However, projects that take a
long time to achieve payback may be more risky than projects with faster paybacks. Standard
ROI calculations do not assign the time-value of money into their calculations. In other
words, companies cannot assess investment requests that need to occur immediately against
risk-adjusted and discounted benefits. In order to account for the time value of money and
adjust the calculation for risk, some companies use a Risk-Adjusted (RA) ROI formula
instead of the standard ROI formula. The calculation of ROI by considering the time-value of
money and risk adjustments is shown below:
ROI
=
NPV (benefits)
PV (costs)
Tarm Definition:
NPV (benefits)
= Net Present Value of the benefits
PV (costs)
= Present Value of the (investment) costs
Although ROI is an important financial metric for assessing and measuring investment
(project) viability and performance, there are situations in which ROI calculation should be
used by taking into account of financial measures such as NPV calculations.
The net present value is a capital-budgeting decision tool used in finance. “The net present
value (NPV) of an investment proposal is equal to the present value of its free cash flows less
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the investment’s initial outlay.” Net present value of an investment can be expressed as
follows:
Metrics
ROI measures the relationship between profits and the investment required to generate them.
There are diverse measures of the investment resulting different forms of ROI. After finding
different measures of return on investment, these financial ratios are used to have meaningful
comparisons of a company’s financial data. The variability of the financial ratios across time
can be considered in order to identify the trends. In addition, the company’s financial ratios
can be compared wita those of other firms in order to determine the company’s place in the
market.
The objective in using these financial ratios when analyzing the financial return on investment
of a company is to standardize the information being analyzed so that comparisons can be
made between ratios of different companies or possibly the same company at different points
in time. In other words, the aim is to standardize these financial data so that comparisons can
be made with industry norms and other standards.
In order to make comparisons of a company with other companies, a peer group of companies
is selected. Industry norms that are published legally can also be used while comparing the
financial ratios between the companies.
There are several measures of return on investment. These are as follows:
Return On Assets
One of the favourable ROI measures used in finance is return on assets (ROA). ROA is often
used as an indicator of a firm’s profitability. ROA ratio compares the net income of the
company with the total assets (equivalently, total liabilities and equity capital).
As the name implies, ROA defines how efficiently a company can squeeze profit from its
assets, regardless of size.
“A pervasive problem when comparing a firm’s performance over time is that the firm’s size
is always changing. Firms of different size are also difficult to compare. Common size
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statements are used to standardize financial statement components by expressing them as a
percentage of a relevant base. For example, balance sheet components can be shown as a
percentage of total assets.
Expressed as a percentage, ROA identifies the rate of return needed to determine whether
investing in a company makes sense or not. While comparing ROA of a company with the
interest rates of which the company should pay in return of its debts (cost of debt), a ROA that
is better than the cost of debt means that the company is pocketing the difference.
Operating Income
Operating income return on investment (OIROI) is another measure of ROI; the attention is
only to the operating profits of the firm. This metric is used while evaluating whether the
management is generating adequate operating profits on the firm’s assets or not. OIROI is a
pure measure of the efficiency of a company while generating the returns from its assets,
without being affected by management financing decisions.
In order to evalute the return on investment of a company, we should ask the question of “Is
management generating adequate operating profits on the firm’s assets?” In answering this
question, we have several choices as how we measure profits as: gross profits, operating
profits, or net income.
Gross profits may not be an acceptable choice because some important information, such as
the cost of marketing and distributing the firm’s product is not included in the calculation.
Therefore it is better to cahoice operating profits or net income in the evaluation of the return
on investment of a company.
Sometimes it is preferred to use operating profits, because this measure of the company’s
profits is calculated before the costs of the company’s financing policies, for example, interest
expense, have been deducted. In this way, the comparison of the profitability of the
companies with different debt-to-equity mixes can be available.
“Therefore, to examine the level of operating profits relative to the assets, OIROI would be
used. It is calculated as follows:
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Operating Income Return On Investment = Operating Income
Total Assets
After finding OIROI of a firm, this ratio is compared with the operating return on investment
of the peer group. If this ratio is higher than that of the peer group, it means that management
is generating significantly more income on $1 of assets than similar firms.”
However, only knowing that a company is earning more than a competitive return on the
firm’s assets would not be satisfactory alone. The reason of why the firm is above the average
should also be determined. To understand this issue, the operating income return on
investment can be divided into two important components:
I. The operating profit margin
II. The total asset turnover
“The firm’s OIROI is a multiple of these two ratios and may be shown algebraically as
follows:
OIROI = (Operating Profit Margin) * (Total Asset Turnover)
Or more completey,
OIROI =
Operating Income
Sales
*
Sales
Total Assets
Components
OIROI: Component 1: The first cmponent of OIROI, the operating profit margin, is an
extremely important variable in understanding a company’s operating profitability. Therefore,
what drives this ratio should be known and taken into consideration.
Because total sales equals the number of units sold times the sales price per unit, and the cost
of goods sold equals the number of units sold times the cost of goods sold per unit, we may
conclude that the driving forces of the operating profit margin are the following:
1. The number of units of product sold; the number of units affects the operating profit
margin only if some of the firm’s costs and expenses are fixed. If a company’s
expenses are all variable in nature, then the ratio would not change as the number of
units sold increases or decreases, because the numerator and the denaminator would
change at the same rate.
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2. The average selling price for each product unit
3. The cost of manufacturing or acquiring the firm’s product
4. The ability to control general and administrative expenses
5. The ability to control expenses in marketing and distributing the firm’s product
These influences are also apparent by looking at the income statement and thinking about
what is involved in determining the firm’s operating profits or income.”
After evaluating seperately each of these driving five forces, we can have an opinion whether
management is effective in managing the mentioned driving forces of the operating profit
margin or not.
OIROI: Component 2: The second component of OIROI is the total asset turnover. It
measures the dollar sales per one dollar of assets. Total asset turonover ratio shows how
efficiently a firm is using its assets in generating sales. The ratio is calculated as follows:
Total Asset Turnover =
Sales
Total Assets
If the total asset turnver of a company is higher than the industry norm,it means that the
company is using its assets more efficiently.
Return On Equity
One particularly useful ROI measure is the return on equity. While answering the question of
whether the owners (stockholders) are receiving enough return on their investments or not,
ROE ratio can be used.
The return of the owners can be measured as follows:
Return On Equity
=
Net Income
Common Equity including par, paid-in capital and retained earnings
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