Return on Investment “ROI” Analysis


We already have a glimpse on the three considerations before we invest. That is, risk, liquidity and return. In this article, we now tackle the last one, which is the very basic reason why we invest and that is return on investment or simply return.

When assessing an investment, you would like to find out if it will earn enough to recover your initial capital investment whether be it invested in stocks, real estate, or in a business.

 

In finance, investing in a business requires a study of the return on investment or ROI. It does not only involve the absolute amount of return but also the time it took to achieve that investment return. And this involves two new finance concepts that I will tackle namely, present value and future value. But before I tackle about the two terms, let me first illustrate an example on return on investment:

Scenario 1: Suppose Jack is in a buy and sell business of second hand cars. He has an initial capital of 200,000. He bought a car worth 150,000. After 3 months he later sold it at 170,000.

Scenario 2: Suppose Jill invested 150,000 in a business. He then recouped his investment by earning 100,000 every year for the next three years.

Which between them has the higher return on investment? Jack had a return on investment of 13.33% while Jill had a return on investment of 100%. Looking at the absolute figures, you may have concluded that Jill had the higher return. Unfortunately, Jack earned it in just 3 months while Jill earned it in three years. So annualizing their investment returns, Jack had earned 53.32% (13.33 multiply by 4) while Jill earned 33.33% (100 divided by 3). So undeniably, Jack earned more than Jill!

We now come to the two finance concepts I mentioned above and these are present value and future value.

Future value is simply the future value of your investment with a time reference of investing today expecting a capital appreciation in some future time. Present value is simply the value at present of an investment to be received in some future time. In finance, there’s a relationship between future value and present value and this is represented by the formula:

FV = PV [(1+I) ^n], where FV is future value, PV is present value, I is interest and n is the number of years. Please note that the symbol ^ denotes exponent.

Manipulating it mathematically, PV = FV / [(1+I) ^n].

To illustrate this, we have the following examples:

Scenario 1: Suppose you want to deposit 100,000 in a bank that gives a fixed 10% interest rate per year.

Scenario 2: Now suppose your trusted and dear friend Ana wants to borrow your 100,000 for two years and promised to give it back to you at 120,000. That’s 20% return on investment for 2 years or 10% interest per year.

Now, the question will be which of the two options will be advantageous to you? Would you rather deposit your money to the bank or lend it off to Ana? It may seem that they both provide the same returns as both have 10% annual return on investment but NO. One is better off than the other!

To show this, lets compute for the present value of Ana’s return of 120,000 after 2 years. That is, PV = FV / [(1+I)^n] = 120,000 / [(1+0.10)^2] = 99,173.554.

Alternatively, we can compute for the future value of 100,00 by depositing it in the bank for 2 years giving an interest of 10% per year. That is, FV = PV [(1+I)^n] = 100,000 [(1+0.10)^2] = 121,000.

So comparing the two options, you are better off by depositing your money to the bank which will give you 121,000 after 2 years. You’re better off by 1,000 as against the 120,000 promised to you by Ana. Where do the extra 1,000 came from? That came from the total interest of your money earned in 2 years. Because you left your money untouched, the interest income earned in the first year also earned an interest in the second year. This is what you call compound interest, which I will discuss, in the next article.

Alternatively, the present value of your money with Ana is just 99,173.554 as compared to the 100,000 present value with the bank. So you’re losing 826.446 if you invested your money by lending it off to Ana. So undeniably, you’re better off by depositing your money to the bank!

Present value and future value are two important finance concepts that will help you every time you make financial or investment decision. Not only do you have to consider that your money must earn, but you must also consider the best option available that will maximize your return on investment.

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Tyrone is a passionate financial literacy advocate. He started this blog on November 2008 when he watched The Secret which talked about Law of Attraction because he wanted to become a millionaire and wanted to know how a millionaire acts. At the age of 26, he achieved his first million. To find out more about him, click here or follow him at Instagram

14 responses on “Return on Investment “ROI” Analysis

  1. I’ve read almost all articles you have written man. But this one really got my interest. Very helpful. I just have a question though. Say for example you have a loan of 100% at fixed-interest rate of 1.5% for 24 months. In any case you pay half of the loaned amount, will there be a possible adjustment on your monthly amortization? I’m really curious about this.

    Thanks! I’ll look forward to it.

  2. Hi Enen, thanks for being a regular visitor of my blog. To answer your question, yes, there will be an adjustment in your monthly amortization. Definitely, the monthly amortization is dependent on the principal amount that needs to be paid so if you reduced the principal amount, therefore, you will pay less monthly amortization. So my advice is if you had a cash windfall and you have an existing mortgage, say a home mortgage, use that windfall to pay your mortgage for you to save a lot on interests expenses. Prioritize to pay the mortgage first rather than spending the windfall in expenses such as new gadgets, vacation trips, and others.

    • Hi Ariane, that would depend on what kind of business are you doing for your feasibility study.

      More often, if the business your doing is new and not yet operating, you have to make some conservative estimates regarding income and expenses to gauge your ROI.

  3. hi tyrone,

    i have this internet cafe business, i hired a bookkeeper to process the montly payments to bir and to prepare financial reports. Now based on the FS i just wanna know how to compute the return on investment (how many months or years should i recover the cost of my investment based on her report)..my internet cafe operated for three months now. Can you give me an idea on how to determine the ROI based on the FS..

    your reply is highly appreciated..

    thanks

    • Hi Angiesa, do you have projected sales or cashflow as part of your FS? That’s a good gauge on how to know the projected ROI of your business.

      If your FS is based on actual results of your business, then you just need to look at the NET INCOME. Compare that figure on the original capital you invested in your business. The time (in months or years) it takes for you to break even since you started operations is your ROI.

  4. what is the indication if the result in solving ROI, NPV, IRR are more than 100%.?this is for our feasibility study.thanks.

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