Return On Investment
(ROI)

Determining of accounting value. Explanation of Return on Investment.

What is Return on Investment? Description

ROI is an accounting valuation method. The ROI is a return ratio that compares the net benefits of a project, versus its total costs. For example, if a project has an ROI of 300%, the net benefits derived from that project are three times those of the expected total costs to implement the project. As such, the ROI calculation represents the relative value of the project's cumulative net benefits (benefits minus costs) over the analysis period, divided by the project's cumulative total costs, and expressed as a percentage.

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 shows up in many annual reports...

Return on Investment overstates economic value

The degree to which ROI overstates the economic value depends on at least 5 factors.

Length of project life. If this is longer, the overstatement will be bigger.
Capitalization policy. If the fraction of total investment capitalized in the books is smaller, the overstatement will be bigger.
Rate at which depreciation is taken in the books. Depreciation rates that are faster than straight-line basis will result in a higher ROI.
Lag between investment outlays and earning back these outlays from cash inflows. If the time lag is greater, the degree of overstatement will also be greater.
Growth rate of new investment. Fast growing companies will have lower Return On Investment.