When investors considers whether to commit capital to a project, they embark on many forms of research. Among the most important, they want to know what their initial capital injection has the ability to return. If the potential profit isn't worth the risk of losing money, the investment is often rejected. One of the simplest metrics for calculating this is return on investment.
Definition
Return on investment is a measurement that evaluates efficiency. What kind of profit generator will a particular investment demonstrate? Every investor wants to make the most money with the least amount of work and the least amount of risk. Return on investment provides the projection of efficiency. Often, the investor will also use the ROI as a comparison to other investments. If an investment in real estate produces a better ROI than the stock market, the investor will often invest in real estate at that time.
Calculating ROI
One of the reasons that ROI is popular is because the calculation is very simple. Unlike other reports or metrics, ROI is simple division. The investor simply looks at the potential monetary gain from an investment and subtracts the cost of the investment. Finally, they divide that number by the cost of investment. This formula produces the ROI. Providing the ROI is positive, the investment will be further evaluated.
Problems
The main problem with this measurement lies in the interpretation of cost. What is considered cost? The simplest example of this is gross cost versus net cost. A shop owner may be more interested in looking at only the cost of acquiring the product. They may not calculate overhead costs in to their margin report. A marketer may compare two different products by dividing the revenue that each product has generated by its marketing expenses although there are many other expenses involved.
Ask Questions
When evaluating ROI that wasn't calculated by the investor, it's important to ask questions. For example, how was it calculated? What kinds of costs were factored in to come up with the total net cost? What line items were omitted from the costs? The investor who doesn't ask questions is leaving the interpretation and calculation up to the person providing the numbers and often, numbers are skewed to make the calculator look better.
Other Metrics
Depending on the type of investment, there may be intangible metrics that are hard to measure but important none the less. As an example, how much of an investor's time is required to make money on the investment? Time needed to manage an investment is time taken from another money-making venture. Does the ROI dictate that the time factor will still yield a high margin of return?
