Essay on Return on Investment

Published: 2021/12/03
Number of words: 2088

1. Introduction

Return on Investment is a widely recognised profitability ratio and is described as a measure of performance and is utilised to assess investment efficiency and compare how various investments are performing. Return on Investment (ROI) attempts to evaluate investment returns relative to the cost. In order to compute ROI, investment returns are divided by the investment cost. Since ROI results are expressed as percentages, they can be utilised to relate the performance of diverse investments. Return on Investment is a popular performance standard due to its simplicity and versatility (Boyd, Epanchin-Niell, and Siikamäki, 2015, pp.23-24). Primarily, the tool can be utilised as a primary measure of investments’ profitability. ROI is simple to calculate and interpret and has diverse applications. For example, investments with a positive ROI are considered viable. Higher ROI can be an indicator for investors and businesses to eradicate or choose the best options. Negative ROI should be avoided since they infer loss to investors. Thus, investors use ROI to make personal financial decisions and determine whether a particular project is worth investing in.

1.1. Problem Statement

Without profitability ratios like ROI, investors and businesses can make poor investment decisions. The emergence of this performance measurement tool has helped investors in making reliable decisions regarding their finances. Since projects with a higher ROI are considered more profitable, individuals undertaking investment decisions need to consider other factors like risks when computing ROI. Poor interpretation of ROI can result in massive financial losses to individuals; as a result, other performance measures need to be evaluated as well, for instance, net present value, and payback period. The assumption investments with higher ROI yield higher returns than others with a lower ROI is a significant problem. The reason being ROI measures the rate of return; however, it does not indicate the amount yielded from the investment.

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1.2. Research Questions and Objective

Return on Investment is a vital measure of investment performance and aid in making feasible decisions. Typically, individuals assume investments with higher ROI are favourable unlike others with lower ROI. The financial ratio evaluates the rate of return investors will receive relative to their investment costs. Thus, it is advisable to effectively measure ROI before deciding whether the ratio is good or bad. The objective of this paper is to evaluate how investors and businesses use ROI to make investment decisions. To achieve this aim, various research questions will be addressed, including; How is ROI applied in investment decision making? How do individuals and businesses consider ROI favourable or unfavourable?

2. ROI and investment decisions

2.1. ROI theory

For most businesses, ROI is an essential measurement standard since it indicates how businesses are utilising equity and cash resources effectively. Small businesses apply ROI in their operation, just like larger corporations. Due to their limited resources, such small businesses derive more benefits from ROI measurement. The concept of return on investment is simple in theory. Businesses and investors desire to earn more funds for every amount they spent on expenses or investments (Boyd, Epanchin-Niell, and Siikamäki, 2015, pp.40-42). As a result, companies can determine they receive more than what they spent if the ROI is more than 0%. A higher ratio displays the company is effectively using its capital. However, ROI should not be considered the sole success measurement and should be combined with other ratios to assess companies’ financial health.

When evaluating possible outcomes and making “go” or “no go” decisions, ROI techniques are useful. Most investors need to minimize risks and conserve capital. By utilising estimated ROI figures, investors can make safer and profitable investment and financial decisions. Small businesses considering expanding to new locations can forecast their profits relative to projected costs to maintain such locations. This decision can be justified by dividing expected returns with estimated costs to calculate the return on investment. A positive ratio aids in making “go” decisions since the investment is healthy, while a negative or zero ratios infers “no go” decisions (Chourmouziadis and Chatzoglou, 2016, pp.298-300). Using ROI assists investors in determining current investment success and forecast future outcomes. For instance, a £4,000 original securities investment is now £4,800. The £800 profit can be divided by the £4,000 original cost to indicate a 20% ROI, which is a more feasible investment than other bank-related investments. The time value of money and risk component is not factored in ROI calculation. There may be a possibility this investment was risky, and investors may similarly have enjoyed a less risky investment with 10% returns. From this example, it is imperative for investors and businesses to combine ROI with other investment analysis tools to manage their investment decisions and financial affairs.

2.2. Calculating and interpreting ROI

Return on investment can be applied diversely on employees, real estate, or stocks and can be computed using different methods;

ROI = (net return on investment/cost of investment) *100%

ROI = [(final value of investment – initial value of investment)/cost of investment] *100%

When interpreting return on investment, it is crucial to note that it is expressed in percentage terms since it is easier to understand compared to ratios. In addition, net returns are included as numerators since they can be positive or negative (Smith, 2015, pp.1-3). Negative ROI implies the investment lost money, and the investors and businesses have less than the original amount spent. Investors and businesses forecast ROI before investing in projects by evaluating the anticipated costs and projected profits. A one-time project with a negative ROI is highly avoided. Other times, investments exhibit a negative ROI after an initial period; however, they improve over time, as seen in new businesses that return profits after several years. A positive ROI infers the investment gained favourably than its costs.

ROI has been applied globally to evaluate the profitability of most projects; however, its global applicability has made it difficult to apply the tool properly. The formula is simple to use, but the difficulty arises in cost and gains definition (Chourmouziadis and Chatzoglou, 2016, pp.310-311). For example, in stocks, investors may compute ROI inclusive of capital gain taxes, and others may not. In real estate, some investors or business may calculate ROI using insurance, taxes, and capital expenditure, while other investors may use the purchase price. Such variability may pose challenges in computing the ideal ROI and obtain effective figures to make investment decisions.

3. Strengths and weaknesses of ROI

3.1. Strengths of ROI

ROI helps financial professionals and investors quickly determine investment prospects, and therefore no much time is wasted in decision making. They can explore and measure possible returns from various investment projects. ROI is a simple and effective tool in investment measurement and can be applied by businesses to assess the market competition (El-Halwagi, 2017, p.611). Other benefits to investors and businesses include;

Enhanced measure of profitability: ROI links net income made in a given department to investments hence offering an enhanced standard of departmental profitability. Departmental managers know they will be evaluated based on the extent of asset utilisation to earn income; thus, ROI motivates them to utilise assets optimally. Furthermore, ROI ensures assets are purchased when they prove to bring returns in accordance with organisational policies. Return on investment primarily focuses on the required investment level (Menezes, Kim, and Huang, 2015, pp.100-101). At a given point in a business unit, each asset has an optimum level that maximises earnings. ROI thus assists managers in determining the rate of return projected from various investment proposals. As a result, they can select investments that improve both departmental and corporate profit performance.

Comparative analysis: return on investment assists businesses in comparing asset utilisation and profitability between different business divisions. Besides, comparison can be made between diverse organisations in a similar industry. For investors, ROI can be valuable in measuring investment performance and related cost of capital to make well informed financial decisions.

Attaining goal congruence: return on investment ensures goal congruence between various departments in an organisation. An increase in ROI in one section improves the overall ROI of the whole firm.

Investment division performance: return on investment is essential in evaluating the performance of investment centres that focus on making investment decisions and earning maximum returns (Menezes, Kim, and Huang, 2015, pp.106-108). Such investment centres can be assessed by ROI regarding the disposal and acquisition of assets.

3.2. Weaknesses of ROI

The time factor is ignored in ROI computation, which is a significant measure drawback. For instance, suppose Mr. A invested £20,000 in Barclays shares in 2012 and sold the investment in 2014 for £30,000. His ROI would, therefore, be 50%. Mr. B invested a similar amount in Aldi shares and sold the investment in 2016 for £30,000, and his ROI is still 50%. However, the time the two invested was different. In two years, A received his 50% returns, but B received a similar return after four years. Due to the “time is money” concept, the 50% actual return is different for both A and B. If the time value of money and inflation is added, the 50% returns earned by B would be less than the 50% made by A.

It is difficult to determine a reasonable definition of investment and profits. Profits have several concepts, such as controllable profits, profits before interest and tax, profit after deducting allocated fixed costs, and profit after interest and tax (El-Halwagi, 2017, p.616-617). Moreover, investment has different meanings like current asset costs, net book value, gross book value, and historical asset costs. When investors and businesses are comparing ROI for several firms, it is vital to ensure such firms use the same accounting methods and policies with regard to overheads apportionment, fixed assets valuation, inventory valuation, and R&D expenditure treatment (Del Bo, 2016, pp.26-29). ROI influences investors and departmental managers to choose projects with higher returns, thereby rejecting projects that could potentially enhance the value of the organisation. Risk is a crucial factor in investment decisions but is generally ignored in ROI. Usually, high-risk investments have a higher ROI, which lures investors. Economic uncertainties may impact such investments leading to liquidation; hence investors lose money. Investments with lower ROI are not prioritised but, in most cases, are less risky, and yield more returns in the long-run.

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4. Summary

In evaluating investment decisions, the application of ROI methodology is useful to businesses and investors. For an extended period, the tool has been applied globally to assess which investment projects are worth investing in. Usually, projects with a positive ROI are viable than others with a negative or zero ROI. Sometimes investments with a higher return on investment are highly preferred by investors, but economists perceive them risky since they produce short term returns. ROI has many benefits to investors, primarily due to its effectiveness in investment analysis; however, its major setback is overlooking the time value of money and risk factors.

5. Conclusion and Outlook

Businesses and investors will continue utilising ROI to manage their investment affairs. In the contemporary business world, investment opportunities keep rising and required practical analysis to assess their viability. Thus, the ROI tool has a critical role in investment and portfolio management. Many investors have avoided huge financial losses while others have made solid financial decisions and received massive profits due to results from ROI. However, to strengthen such results, analysts need to integrate ROI with other performance measurement tools to ensure less risky and more effective investment decisions are made by businesses and investors.

6. References

Boyd, J., Epanchin-Niell, R. and Siikamäki, J., 2015. Conservation planning: a review of return on investment analysis. Review of Environmental Economics and Policy9(1), pp.23-42.

Chourmouziadis, K. and Chatzoglou, P.D., 2016. An intelligent short term stock trading fuzzy system for assisting investors in portfolio management. Expert Systems with Applications43, pp.298-311.

Del Bo, C.F., 2016. The rate of return to investment in R&D: The case of research infrastructures. Technological Forecasting and Social Change112, pp.26-37.

El-Halwagi, M.M., 2017. A return on investment metric for incorporating sustainability in process integration and improvement projects. Clean Technologies and Environmental Policy19(2), pp.611-617.

Menezes, M.B., Kim, S. and Huang, R., 2015. Return-on-investment (ROI) criteria for network design. European Journal of Operational Research245(1), pp.100-108.

Smith, C., 2015. Portfolio Management. Wiley Encyclopedia of Management, pp.1-3.

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