Let’s face the ugly truth: it can be pricey to launch or run a business! Only very few business owners have the funds in hand to start things off without some assistance. Those who may not have the luxury of ample funds may look for funding through a regular loan from friends and family, or from investors if they are starting a small business or hoping to expand their current one. Friends and family lend their money to you based on trust and knowing they will be paid back, however it does not work the same with investors. Therefore it is critical to know what investors expectations are in a potential business collaboration.
Investors are not mere lenders. Lenders provide you with capital with the expectation that you would repay them with interest, whereas investors provide you with capital in exchange for a portion of your company, expecting a certain Return of Investment (ROI) from projection given or the past performance.
What is Return of Investment (ROI)?
Return on investment, or ROI, is an acronym frequently used in business to describe current and previous financial returns. Understanding ROI is crucial to an investor as ROI enables you to determine the profit or loss your investment has generated when you invest money in a business venture or an investment.
How to Calculate Return of Investment (ROI)?
Return of Investment (ROI) is calculated by dividing the net profit (or loss) from an investment by the cost of the investment. It may be expressed as a ratio or by percentage, but the latter is more common. The efficacy or profitability of various investment options can be compared easily when it is expressed in percentage.
ROI = (Net Profit / Cost of Investment) x 100
ROI = (Present Value – Cost of Investment / Cost of Investment) x 100
How does an investor use Return of Investment (ROI)?
Two important elements are frequently taken into account by investors when deciding whether to invest in a company or other investment opportunities: the ROI percentage and the time it takes to get a return on their investment.
Regular investors can use ROI to review their portfolios, and it can also be used to evaluate nearly any kind of expenses done.
For instance, to determine the viability of a business and make the best decision, an angel investor could compare the potential ROI of the companies, dividing the annual profit or income by the current investment amount.
On the other hand, a business investor could, for example, utilise ROI to determine the return on the expense of advertising. A 600% return on investment (ROI) would be received by the business if $3,000 in advertising resulted in $18,000 in sales. Similarly, while deciding whether or not to invest in new equipment, the business investor can compute the ROI by utilising the company’s value as the investment’s value and the cost of the equipment or technology as the investment’s cost.
More often than not, as opposed to common belief, when an investment has a high rate of return, it typically takes longer for investors to see their returns. Whereas, a lower ROI percentage will bring faster returns.
A seasoned investor would know that ROI is just a number and it cannot eliminate risk or uncertainty. It can only be as accurate as the data that was factored into the calculation. He or she may still need to account for the possibility that the predictions of net earnings may be either overly optimistic or underly pessimistic when using ROI to make investment decisions in the future. Additionally, like with other investments, past performance is no assurance of future performance.
What would be a good Return of Investment (ROI) to an investor?
Good is a subjective term. 7% or more in ROI is often regarded by experts as a respectable ROI for stock investments, after accounting the inflation. This figure serves as the industry standard because it represents the S&P 500’s average return, an index that measures the overall performance of the U.S. stock market.
This number represents an average; the actual return may vary from year to year. However, performance will often level off at this point.
Rather than using a simplistic comparison, choosing the right ROI for investing strategy calls for significant thought from an investor. An investor’s financial necessity is the most crucial factor to take into account when calculating a solid ROI.
The notion of a successful ROI for a young investor would be different from a retiree looking to augment their income. The retiree would define a decent rate of return as one that produces enough recurring income to support them comfortably. Naturally, how one retiree defines a comfortable lifestyle may not be the same as how another defines a good return on investment.
Why is ROI commonly used by an investor?
1. Easy to Understand and Calculate
Due to its simplicity, the return on investment metric is commonly utilised. There are only two numbers needed: the benefit and the expense. The ROI formula is simple to use because there is no single, universally agreed-upon definition of what a “return” is because it might mean different things to different people.
2. Universally Recognized
Since return on investment is a concept that practically everyone can understand, using the metric in conversation almost always results in understanding.
3. Capability for comparative analysis
More business-to-business comparisons of investment returns can be made due to its broad use and simplicity of calculation.
4. Profitability Determination
ROI has to do with the amount of money that was made and then invested in a particular business unit. A more accurate indicator of business or team profitability is provided by this.
Why is ROI still not the only Formula an Investor considers?
One of the most commonly utilised investment and profitability ratios nowadays is ROI. It does, however, come with significant shortcomings.
1. The Time Factor is Not Taken into Account
An investment option is not always preferable when the ROI is larger. Two investments, for instance, both have a ROI of 50%. While the second investment takes five years to generate the same yield as the first, the first investment is finished in three years. The larger picture was obscured by the identical ROI for both investments, but when the time factor was included, the investor could immediately identify the superior choice.
An investor will have to compare two instruments over the same time frame and under identical conditions.
2. It Is Possible to Manipulate ROI
Depending on the ROI formula applied in the computation, a ROI calculation will vary between two people. In some instances, certain expenditures may not have been factored in during the calculation of the ROI, such as maintenance charges, property taxes, legal fees, sales commissions, etc. A reduced cost will result in a seemingly higher ROI return.
Hence, a professional investor will only consider the genuine ROI, which takes into account all potential expenses incurred when each investment increases in value.
3. Unable to factor in nonfinancial benefits
A company can calculate the net profit and total costs to determine ROI by using precise dollar numbers, using the ROI for new workspace arrangement as an example. It is challenging to estimate the value of increased work spirit brought on by workspace arrangement as it is intangible.
4. Varying corporate policies
Not all companies follow the same accounting practices or measure investments the same way. To navigate this, investors can research company policies and ensure the company follows traditional investment practices.
What are the other metrics that an investor would take into account?
Internal Rate of Return (IRR) is another widely used metric to measure the profitability of an investment, that takes into the account of the time value of money. IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.In general, the higher an IRR, the more attractive an investment is to undertake.
ROI is a rather simple calculation that shows the amount an investment returns compared to the initial investment amount. IRR, on the other hand, provides an estimated annual rate of return for the investment over time and offers a “hurdle rate” for comparing other investments with varying cash flows.
What are the other factors that an investor would consider?
An investor will often consider the followings:
1. How much risk am I willing to take?
2. What will happen if I don’t get my money back?
3. How much profit must I make before I am willing to risk losing money on this investment?
4. If I do not make this investment, what else could I be able to accomplish with this money?
ROI is an intelligible and simple-to-calculate indicator for assessing the effectiveness of an investment. You can evaluate investment alternatives side by side using this common calculation.
However, as ROI does not take risk or time horizon into consideration and necessitates an exact measurement of all expenditures, it cannot be the only indicator investors use to make their judgments. When reviewing an investment, using ROI might be a good metric to start, but other factors and metrics would be taken into account by a seasoned investor to make the most suitable choice of investment that best meets their individual investment goal.
