Return on Investment

Firms and individuals have a variety of alternatives for employing their scarce capital. Return on investment (ROI) is one of the many analytical methods individuals and firms employ to aid in the allocation of funds. Although there are many definitions of ROI depending on the context, a working definition can be the amount that an individual or firm earns on the capital invested.

From the viewpoint of the individual, ROI is often considered in the context of investing in a common stock. For example, if the investor buys 100 shares of XYZ Corp. at $20 per share and sells the same stock at $25 per share (ignoring commissions), the ROI is (25 – 20)/20, or a 25 percent ROI. The question of whether the 25 percent ROI on XYZ Corp is “good” depends on the benchmark to which the ROI is compared. The most common benchmark to which common stock ROIs are measured is the S&P 500 Index (which measures the return of the 500 large stocks on an unmanaged basis). For example, if the S&P went up 30 percent during the same period of ownership, the XYZ ROI of 25 percent would be considered a poor relative ROI. Conversely, if XYZ Corp. stock went down 10 percent when the S&P 500 went down 15 percent, XYZ Corp. would be considered a good relative investment because it outperformed its benchmark.

From the viewpoint of the corporate financial manager, ROI is employed in the process of selecting among the various capital project investment opportunities available to the firm, such as building a new plant, launching a new product, entering new markets, and so forth. Capital budgeting is the process the manager employs to determine which project(s) a firm should undertake to maximize firm value and, hence, the firm's ROI to shareholders and creditors.

There are many methods to rank the attractiveness of a firm's capital projects, including payback period, internal rate of return, and net present value. In general terms, an investment to the firm has value if the return on investment is more than it costs the firm to acquire. How the ROI is calculated depends on the method employed by the manager. As a rule of thumb, the best measure of ROI in the capital budgeting context is the net present value method, which indicates that the projects that provide the highest positive net present value should be given the highest rank.

There is no magical ROI threshold that is appropriate for each security investment or capital budgeting project. Each investment must be evaluated according to its risk profile, the firm's cost of capital, and norms of the industry in which the firm operates. Moreover, it is necessary to evaluate the ROI over relatively long periods of time, say 5 to 10 years, to get a feel of how a firm deals with the ups and downs of the business cycle.

Public relations is one of many organizational functions that is called upon to enhance businesses' ROI. For this reason, strategies such as publicity and promotion are used to support marketing. Also, public relations can help reduce costs by successful crisis and issues management.

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