One of the most bandied-about corporate terms seems to be “ROI.” Everybody loves to quote it, but it seems to be a term often accompanied by confusion, contention, and sometimes even downright annoyance. In this first of a series of posts on ROI, we will discuss one key learning from the world of corporate finance.
Imagine this scenario. The CFO’s prepped for a discussion on the merits of a particular technology investment one of the business units is asking for. The financial analyst has done a good job of crunching the numbers, and has given the CFO some pertinent facts to shape the discussion: they can fund the project at 10%, get a return of 20%, recoup the investment in 18 months, and net $1million profit in the process for the shareholder. Looking good.
In walks the Business Unit Director, and after a brief summary of the operational benefits of making the investment, declares with excitement and pride, “And the ROI is 187.36%!” Silence fills the room. 187.36%? Where does that come from? What does that even mean? Right off the bat, we have a disconnect. Not a good start. The CFO’s suspicion aroused, a series of probing questions follows. 30 minutes of interpreting and translating later, the CFO eventually understands the Director had quoted a 5-year percentage return rather than the customary annual one, hadn’t bothered to factor-in the time value of money (“a dollar today is worth more than a dollar tomorrow”), had ignored the amortization of the project’s expenses, and had based the ROI calculation on the projected earnings stream rather than cash flow.
The CFO decides, after all, that when viewed through the conventional financial lens, the investment’s nevertheless a good one. The end result in this case is that after triaging the presentation, positive consensus is reached. The unnecessary hiccup caused by the Director’s failure to follow financial protocol was overcome. But that is not always the case. In another example, the presenter’s temporary loss of credibility is not recovered and a rival project with the same returns, but without the hiccup, gets the funding. Maybe the CFO’s having a bad day, and it is simply so “insulted” at the naiveté of the pitch he / she switches off to the project. There are, after all, many to choose from.
Which leads to the first “Do.”
When in Rome
Do as the Romans do. You don’t make a presentation to a Parisian audience in German, so don’t invent your own way of quantifying ROI. There’s a set way to measure ROI anyone who’s been through Finance 101 has been taught. It becomes second nature to the financial professional. It serves the desired purpose. It’s been around a long time. Unless you’ve discovered a better method on your way to the Nobel Prize for Quantum Physics, leave it alone and follow the crowd. There’s safety in numbers.
Include the key metrics of the protocol:
- Net Present Value (NPV $)
The larger the NPV, the greater the attractiveness of an investment. It captures the amount of profit — expressed in today’s dollars — a shareholder receives after paying back the cost of the investment. A project with a NPV of $2million is preferable to one of $1million.
- Internal Rate of Return (IRR %)
An intuitive measurement that shows the percentage return the investment will generate – if I have to pay 10% to get the money to fund the project and get 15% back from the investment, good deal. Use NPV, rather than IRR, as your primary tool to rank projects, though. A 20% return on an investment of $50k isn’t better than a 15% return on a larger one of $500k.
- Payback (months)
For example, after 1 year, the total projected project benefits to that point in time equals the amount initially invested, so the payback is 12 months. The length of time it takes you to recoup the initial investment is a measure used to gauge the risk of a project – the longer it takes you to get your money back, the riskier, other things equal.
None of these metrics is difficult to calculate, guidance can be found in any introductory Finance text book, and public sources such as Wikipedia have decent overviews. Excel has built-in mathematical functions to hold your hand through the calculations.
So, unless you’re presenting at a company that’s decided to invent its own investment metrics, start your ROI discussion on the right foot and show you know the ropes!