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What to know about ROI.

Return on Investment (ROI) is the cash or profit gained from equity dollars invested. It is also sometimes referred to as Return on Equity (ROE). The return can be expressed as a dollar amount or converted to a percentage by dividing the total equity returned by the equity invested. Typically, returns are calculated on an annual basis and referred to as "annual rate of return."

Dollars Received / Dollars Originally Invested = Rate of Return

Return can also be calculated on total capitalization. Total capitalization is the sum of all the dollars of debt and equity invested.

Dollars Received / (Equity + Debt Invested) = Return on Total Capitalization

If $50 were received in year one as a return on $200 invested, the rate of return would be 25 percent, calculated as 50/200 = .25 or 25 percent.

If the investment were only held eight months and the calculated ROI was .25, an annualized return can be calculated by dividing the ROI by eight (months) and then multiplying the product by twelve (the total number of months in a year).

Annualized ROI = (8-Month ROI/8) x 12 = (0.25 / 8) x 12 = 0.03125 x 12 = 0.375 or 37.5%

Similarly, if the ROI were for a 54-month period, it could be annualized by dividing the raw ROI by 54 and multiplying by 12.

Annualized ROI = .25/54 x 12 = .05556 or 5.56% annualized rate of return

These returns can be calculated after the fact, as above, or the formula can be used to calculate the amount that can be invested to purchase an income stream to yield a desired rate of return. For example, if a given investment is expected to earn $50 and the required rate of return is 25 percent, the amount that can be invested is $200. Using basic algebra to rearrange our original formula for calculated rate of return, we obtain the formula to calculate the investment amount that will yield the desired rate of return given the expected amount of income or cash flow.

x (Dollars to Invest) = Dollars of Cash Flow/Desired = Rate of Return

x = $50 /.25

x = $200

When considering the return one should require on an investment, i.e., the required rate of return (aka discount rate), it's helpful to study the returns earned historically on various types of investments. The table below lists the average annual return earned from 1926 to today on several types of investments. Of course, the least risky investment listed is the Treasury Bill. Generally, the "T-Bill" is considered risk free. The riskiest investment listed is Micro-Cap Stocks, i.e., equity in smaller publicly traded companies. The rates of return earned are commensurate with risk. This is because the return earned (and demanded) on an investment must fully compensate for the risk inherent in the investment.
                                   Average Annual Returns (3)

Inflation                                  3.0% (1)
U.S. Treasury Bills (30 days)              3.7% (1)
U.S. Treasury Bonds (5 years)              4.3% (1)
U.S. Treasury Bonds (20 Years)             5.1% (1)
L.T. Corporate Bonds (20 years)            5.7% (1)
Large Cap. Stocks                          8.9% (1)
Micro-Cap. Stocks                          12.0% (2)

(1) Source: SBBI Valuation Edition 2011 Yearbook. Returns
are the average annual total (income and capital appreciation)
arithmetic mean for 1926 to 2011 in the United States.

(2) Micro-Cap Stocks is defined as the portfolio of stocks
comprised of the 9th and 10th deciles of the New York Stock
Exchange. According to the Center for Research in Security
Prices, University of Chicago, the average capitalization of
Micro-Cap companies from 1926 to 2011 was $68 million.

(3) Returns are return to total capitalization (debt and equity).

Each investment type listed is publicly traded because the information needed to make the return calculation is available only for public investments. So, when one's interest is a private investment such as real estate or a private business, we must extrapolate from the information in the table.

If we want to relate the returns on the table to small privately held businesses, we can say the public investment type that has the most common characteristics is Micro-Cap Stocks. Further, we can safely assume that the return we should earn on an investment in a private business should be higher than what is earned on Micro-Cap Stocks for the following reasons:

1. Ownership in a private company is highly illiquid compared to ownership in even a small publicly traded company, i.e., Micro-Cap company.

2. The private business you invest in will in all likelihood be smaller and less diversified than the average Micro-Cap-size public company. Similarly, it will thus have comparatively less access to capital, higher cost of capital, diminished ability to attract and retain talent, etc. All of these factors increase risk.

Remember: the required rate of return on an investment reflects the degree of risk of the investment. Risk is the degree of uncertainty that a given investment will actually yield the returns (income) that are anticipated. As risk rises, so must the rate of return--to compensate the investor for the risk he or she bears. Similarly, as risk rises, the price one should be willing to pay for the cash flow stream should fall.
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Title Annotation:INVESTMENT; Return on Investment
Publication:The Business Owner
Geographic Code:1USA
Date:Mar 1, 2013
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