R is for ROI (Return on Investment)

Graphic from JFitzgerald.com.

ROI is overrated.

Return on Investment (ROI) is one of the most widely used financial ratios, like Earnings Per Share (EPS), Current Ratio (CR), or Debt to Equity (DE). These things grow like weeds, once fledgling MBAs get hold of an HP 12-C calculator. Soon every conversation gets sprinkled with acronyms. Then, executives try to apply financial ratios to everything, and anyone who objects that you can’t put a value on everything is told to take a hike.

Net Profit means after subtracting the Cost of the Investment. Graphic from investinganswers.com.

Not Entirely Useless

ROI can be a useful measure, especially in making choices. Suppose you have a portfolio–that’s investor slang for “bunch of different”–investments that you made of differing amounts. You want to know which one has grown the most consistently over the last five years. An ROI comparison makes the numbers comparable.

Or, suppose you have $10,000 to spend on a project. You can choose one which has a 90% change of receiving $12,000–that’s an 8% return after the cost. Or one that has a 40% chance of earning $30,000–that’s a 20% return after cost. The possibility of a significantly bigger payoff might attract you to a project with a bit more risk, given the reward.

Management may also employ the use of a hurdle rate, a company-wide standard rate that every project must cross, usually somewhere between 12 and 17%. In this case, our Project A wouldn’t get on the drawing board despite its sure thing attraction while Project B would be green-lighted.

The textbook examples are all very simple until you actually try to use them.

Example from Investopedia.com.

Theory vs. Practice

Everything gets complicated very quickly when you have to factor in everything. Start with the denominator: the costs. Are you including not just the equipment and software, but also everyone’s time? Project managers try to exclude costs to make the denominator lower, claiming you should exclude buildings, which have to bought anyway, or other fixed costs, which are already “sunk.”

Then, how about the return. How long do you wait to count all of it? If it’s a multi-year investment, do you only look at the ROI after a year? (of course not). How many years out do you go before it should pay off? Also, if it’s multiple year, then you really should factor in the time value of money, meaning you should discount future years, usually by the hurdle rate. You knew that calculator with the NPV button was going to have to come in somewhere, right?

But let’s talk about that hurdle rate, which is often tossed around as if it’s immutable. It’s not. Once upon a time, in the 1980s, interest rates ran 20%, so hurdle rates had to be much higher- for investments to clear what you could earn on a CD. Interest rates since the Great Recession and even since last year are back down in the 1-2% range. The stock market might earn 3%, -11%, or 25%. What’s the “correct” hurdle rate?

And what if the return’s not exactly quantifiable?

Graphic from blog.vantagecircle.com.

ROI on Employee Benefits: What Price Good Health?

Companies have increasingly invested in employee benefits, especially since the young, sexy dotcoms started sprinkling largesse over their millennials, between free Cokes and letting people bring pets to work. Since benefits cost money, executives then want to know the ROI of the benefit programs.

One blog even outlines a calculation that Health Wellness programs have an ROI of 500 percent, whereas Financial Wellness ROIs are between 300 to 1500 percent. Wow! 1500 percent! I’ll take that. Calculating ROI for employee benefits is an interesting intellectual exercise, but not much more. It might make more sense to factor in how many employees use the various programs and whether the employees think they get value from them.

Managers also use improved productivity as a measure of increased morale. Yet, isn’t increased employee morale a good idea for its own sake? Shouldn’t we want to make our employees happy–if it doesn’t cost too much–because happy employees are better? Not just because they don’t spit in the coffee anymore?

ROI on Education

This one’s the worst. People try to reduce the value of a college education to an ROI, which often show that expensive (private) colleges are less valuable than less expensive (public) ones. One site comments that heavy-duty schools like Harvard can’t compete with the Colorado School of Mines or SUNY Maritime College.

Graphic from mentalup.co.

An ROI on education is ludicrous on so many levels. First of all, let’s discuss whether the money spent on college should be compared with how much you earn in the job you get after college. Are those comparable? What’s the ROI on Vincent Van Gogh’s art education? He didn’t make any money in his lifetime. How about Charles Ives, who studied to be an insurance salesman? Mick Jagger started at the London School of Economics studying accounting, but dropped out to be a musician. Bummer!

Harvard’s not for everybody and not everyone can get into Harvard, but what’s the value of the network of contacts you make while you’re there? How do you factor that in? What you if you marry someone rich that you meet–does that mean you didn’t “earn” anything for the numerator of ROI?

What if you get a degree in one subject, then never “use” it? Does that make your ROI zero?

I got an English degree, then became a cost accountant and a financial consultant. Did I waste my money, then? Did I never use the degree? When I was writing all the reports and all the emails, wordsmithing to find the most persuasive adjectives for projects? And, what about now? What’s the ROI of my blogging?

You can be the judge of that.

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