Friday, June 27, 2014

Return On Investment

Return On Investment (ROI) is an accounting valuation method.

In PR we use it a lot. I am not sure we realise what we are talking about.

But it is not very robust.

Because the numerator (Net Income) is an unreliable corporate performance measurement, the outcome of the formula for ROI must also be unreliable to determine success or corporate value.
However the ROI formula still keeps showing up in
many annual reports...

The degree to which Return On Investment (ROI) overstates the
economic value depends on at least 5 factors:
1. length of project life (the longer, the bigger the overstatement)
2. capitalization policy (the smaller the fraction of total investment capitalized in the books, the greater will be the overstatement)
3. The rate at which depreciation is taken on the books (depreciation rates faster than straight-line basis will result in a higher ROI)
4. The lag between investment outlays and the recoupment of these outlays from cash inflows (the greater the time lag, the greater the degree of overstatement)
5. the growth rate of new investment (faster growing companies will have lower Return On Investment )


Net Income / Book Value of Assets = ROI

(Better) alternative:

Net Income+Interest (1-Tax Rate) / Book value of Assets = Return On Investment

You may find more information like this from Steven M. Bragg in his book  Business Ratios and Formulas : A Comprehensive
Guide  and Ciaran Walsh - Key Management Ratios