The many formulas and measures that are available to calculate return on investment can make it a subjective task. This overview explains how to calculate the return on investment. It looks at what you should measure and how you can arrive at a conclusion. This guide provides further information on how to use return data to make objective decisions.
What is the best return for me?
Upon completion of a financial projection for a new project, the first question asked is often, “What’s my return?” The anticipated reply is a simple percentage or an empirical value representing projected profits. However, more often than not, the actual response will be, “It depends.” It depends on what one wants to measure. Return on investment is not necessarily a measurement itself; on the contrary, it is more a category of measurement tools designed to provide insight into the operational results of an investment or business venture.
Investors choose different metrics to evaluate their operational performance. Investor preference can sometimes determine how return on investment will be measured. In other cases, standard operating procedures in an industry may dictate the method. It is important that investors fully understand the purpose of any measurement. You should also make sure that the same measure is used for multiple investments. Different tools can lead to apples-and-oranges comparisons.
The return can be calculated by going concern measures that are calculated on a monthly, quarterly, or annual basis. Some steps are designed to show the return on an entire project. In the 21st century, it has become more important in areas like sustainability, environmental impact, and social responsibility. Finance has responded to this by adopting the idea of calculating the social benefits that can be derived from various business ventures or investments. In response, multiple tools are being created to try and measure the social return of investment.
We will describe the return measurement procedures for a projected company called ABC, Incorporated. This is a real-life example of a client I had in the past but with some numbers modified.
Return on Investment Measures for Going Concerned
The types of returns are divided into two categories: those that come from a continuing concern and those that come from an investment. The first reflects the total returns of a business, which is assumed to continue operating indefinitely.
The going concern returns provide a comprehensive picture of the overall performance of an enterprise.
Return on Assets
Return on Assets is a measure of how effectively assets are used in a venture.
ABC Corporation’s ROA for its first five years of operation would be:
ROA is an important measure because it represents the profit per dollar invested in assets. In year 3, ABC will generate an estimated $18,21 per $100 in assets used in the business. As is true with many return calculations, the empirical values are not the whole story. As an example, let’s ask, “Is 18.21% good return on assets?” The answer, unfortunately, is “It Depends”!
Understanding the industry and its performance is the first step in evaluating ROA. Imagine that in ABC’s sector, the average return is 20.00%. ABC’s performance was clearly below average in its early years. Note the improvement in ABC’s ROA. By year 5, it should be slightly higher than the industry average.
In order to be of maximum value, ROA must be considered as an ongoing measurement. The point-in-time ROA has value, but the overall trend analysis has more value.
The Failing of Empirical Dollar Returns
In most cases, it is a mistake to use empirical profits (dollar values) as a measurement of return on investments. British Petroleum, for example, had a net profit of approximately $3.4 billion in FYE 2017. Undoubtedly, it is a huge amount of money. BP’s ROA is 1.23% for FYE 2017. This is significantly lower than many of its competitors.
Comparatively, US 10-year Treasuries yielded an average of 2.33 percent during 2017. If BP had liquidated its $ 277 billion in assets and invested them in US Treasuries, it would have received a higher return with a lower level of risk. Hence, relying on empirical dollars is not a good way to measure recovery.
Total Assets Employed
Each industry shares similar operating processes. For example, industrial companies invest more in their assets. Equipment requirements for oil companies are enormous. Service-based businesses, on the other hand, have far less assets. Compare Facebook with Exxon.
Facebook’s ROA, while comparable to Exxon’s Net Income, is much higher. At first glance, it might seem that Facebook is doing better than Exxon. Note the asset differences. Exxon’s assets are 4x greater than Facebook’s. Exxon, as previously mentioned, performs better than its competitors in the industry on a ROA basis. It is important to note that comparing ROAs across sectors may not be possible or reasonable.
It is also important to remember that some companies may have fewer assets than usual if they are using leased assets instead of owned assets. Leased assets are not included on a balance sheet. Therefore, the total support for a company that rents investments would be much lower than if they owned them. In this case, the ROA of the company leasing assets will be much better. The observer must compare not only the ROA but also the amount of help on the balance sheet of each business. This is another way to ensure true comparative ROA calculation.