What’s My ROI?
Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.
What is my ROI — my Return on Investment? Easy: it’s the profit divided by the cost.
How do you compare ROI for different investments over time? And how do you account for maintenance and upkeep dollars during this time? Uh-oh!!!
Everyone wants to know what they will get for investing money into something. If I invest $1M, then in 2 years I will get $1.2M. It is a pretty simple concept. It should be simple to calculate as well, right? It isn’t completely simple, but it is manageable if you understand a few key concepts…
Time Value of Money
If I told you I can guarantee you a 1000% return, you would probably be ecstatic. What if I told you it will take 1000 years? You wouldn’t be so happy. We take for granted money and time go hand-in-hand. This is why when many figure ROI calculations they usually reflect a payback time, or how long will it take to pay back the initial investment.
We’re really talking about cash flow — how much money and when. Time and money are both equally important.
Great! Problem solved? Not so fast. A 4-year simple payback means the average annual rate of return is 25%, but it tells nothing of the initial investment cost magnitude and its overall impact. A simple payback calculation cannot fully explain the ramifications of investing in one project over another. In fact, no one calculation can fully explain the “opportunity costs” associated with making one monetary decision over another.
Opportunity Cost
In economics class, we learn there is always an opportunity cost with every monetary decision we make. Spending $5 on a cheeseburger means you cannot spend that $5 on a sundae. The opportunity cost of the cheeseburger is the sundae — the sundae is the next best thing that could be done with the money. In the real world, however, there are hundreds of options or opportunity costs when it comes to monetary decisions.
One of the “best” risk-free options historically used for comparison in finance is a 10-year treasury bill (note: this is not always optimal and not always risk-free, but it is a historically significant indicator). I really believe everyone defaults to the T-Bill because they don’t fully understand what they are calculating. The only real reason I can think of a corporate finance guru actually putting money into a T-Bill is to avoid paying importation tax on money made outside of the country. Other than this strategy, no one would “invest” in T-Bills long-term in lieu of a viable fixed investment. So why do we use it as an opportunity cost? Because we need to set a baseline for other optional investments in order to make sure we are doing the best with the capital given to invest.
Bottom-line, for any one capital decision, there need to be at least 2 or 3 options evaluated in order to start to understand the cash flow impact.
The Ever-Elusive Risk
You are now looking at 2 options that each cost $1M initially, they all fare much better than the T-Bill baseline, and they all promise 10% annual returns. Now what? Risk evaluation!
Risk is an easy to comprehend metric, but actually measuring it is not so easy. It is simply an order of magnitude for which decisions may not turn out as expected. Risk is entangled with the probabilities of success and failure. Simply multiplying the probability of an event occurring by the potential loss (or gain) associated with the event will yield a measure that can be ranked. The resulting number does not handicap the amount that could be lost (or gained), but this gives something that can be used to compare options.
In the example starting this section, option 1 has a 10% probability of failure with $250,000 total loss potential (including revenue loss if not completed, contingency overruns, and debt service). Option 2 has a 25% probability of failure with $150,000 total loss potential.
Option 1’s risk magnitude is 25,000 while Option 2’s is 37,500. Option 1 is probably the safer of the two.
Risk = probability of event occurring x total loss (or gain) if the event occurs.
The complexity is in adding up all the potential losses of revenue, contracts, debt servicing, commissions, etc. This takes a lot of forethought, but the true magic is in coming up with a probability percentage. The best method I’ve found is using heuristics or, in other words, using a practical approach with rules of thumb, intuitive judgment, and common sense.
Modeling Cash Flow
Time value of money, choosing proper options to evaluate, and risk estimation all require a very important skill — accurately modeling cash flow. Instead of getting bogged down with the entire analysis, break it down into month-by-month chunks. Think of it as you would personal finances. What do I need to spend each month for this option? What are my utilities, maintenance, taxes, repair contingencies? Start with the first month and work through 12 months. Copy this into the next 12 months, then look for a pattern. Fill in year 3, 4, 5… This spreadsheet will grow very fast without much effort.
Consultants get paid tens of thousands of dollars to put these models together (believe me, I have), but there is really nothing difficult about creating the model. It is just tedious. The great thing about spreadsheets: they can constantly be changed and refined. This is not just an exercise for making a decision and then file and forget it. These numbers should be pulled out monthly to make sure the project is on course. It is the old adage of running the business by the numbers. The model contains the numbers to pay attention to.
Modeling cash flow for 20 years is a little tedious but the end result is a complete understanding of the particular option and a preliminary budget for the life-cycle.
Many people abhor the thought of modeling financial options and calculating ranges of returns. I completely understand — I hate it myself. However, I hate losing money more. It’s in the paying attention to details when we can truly make or break a financial venture. Watching paint dry might be more exciting, but the details are always what makes the most profit.
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Originally published at roireports.com.
