Investment Decisions

Some investment decisions are easy to make.

• Perhaps, a government safety regulation makes an item of capital expenditure compulsory.
• Or perhaps, an essential piece of machinery breaks down and just has to be replaced.

Many other investment decisions are not nearly so clear cut and hinge on whether the proposed expenditure will generate sufficient future cash savings to justify itself.

There are many very sophisticated techniques for aiding this decision.  Here are three techniques that are commonly used:

• Payback
• Return on investment
• Discounted cash flow.

Payback

This has the merit of being extremely simple to calculate and understand.  It is a simple measure of the period of time taken for the savings made to equal the capital expenditure.

Return on investment

This takes the average of the money saved over the life of the asset and expresses it as a percentage of the original sum invested.

Discounted cash flow.

This technique takes account of the fact that money paid or received in the future is not as valuable as money paid or received now.  For this reason, it is considered superior to payback and to return on investment.  However, it is not as simple to calculate and understand.  Discounted cash flow involves bringing the future values back to its Net Present Value.

Is it working? Always measure and monitor your investments.

You can't tell if something is working unless you measure it.

Set a return on investment for your projects to make a contribution, with a deadline.  Monitor the progress towards that at regular (monthly) intervals.

Return on Investment

Return on Investment (ROI)

This measures the overall profit or loss on an invesment expressed as a percentage of the total amount invested or total funds appearing on a company's balance sheet.

Why it is important

Like ROA or ROE, ROI measures a company's profitability and its management's ability to generate profits from the funds investors have placed at their disposal.

One opinion holds that if a company's operations cannot generate net earnings at a rate that exceeds the cost of borrowing funds from financial markets, the future of that company is grim.

How it works in practice

The most basic expressio of ROI is:

ROI = net profit / total investment

A more complex variatio of ROI is an equation known as the Du Pont formula:

ROI (Du Pont formula )
= (net profit after taxes/total assets)
= (net profit after taxes/sales) x (sales/total assets)

Champions of this formula, which was developed by the Du Pont Company in the 1920s, say that it helps to reveal how a company has both deployed its assets and controlled its costs, and how it can achieve the same percentage return in different ways.

For shareholders, the variation of the basic ROI formula used by investors is:

ROI
= [net income + (current value - original value) / original value ] x 100

For example, somebody invests $5,000 in a company and a year later has earned $100 in dividends, while the value of the shares is $5,200, the return on investment would be:

ROI
= [100 + (5,200 - 5,000) / 5,000 ] x 100
= [(100+200)/5,000] x 100
= 6%

TRICKS OF THE TRADE

• Securities investors can use yet another ROI formula: net income divided by shares and preference share equity plus long-term debt.
  
  
• It is vital to understand exactly what a ROI measures, for example assets, equity, or sales. Without this understanding, comparisons may be misleading or suspect. A search for "return on investment" on the web, for example, harvests everything from staff training to e-commerce to advertising and promotions!
  
  
• Be sure to establish whether the net profit figure used is before or after provision for taxes. This is important for making ROI comparisons accurate.

Return on Investment

Return on Investment

Abbreviated as ROI, refers to a measure of a corporation's profitability, equal to a fiscal year's income divided by common stock and preferred stock equity plus long-term debt.

ROI measures how effectively the firm uses its capital to generate profit; the higher the ROI, the better.

What is your optimum Return on Investment?

2008/12/13
Your Money: What is your optimum ROI?

By : Yap Ming Hui

RETURN on Investment (ROI) is an important ally in attaining financial freedom. ROI can help us overcome the threat of excessive spending and inflation. If we are serious about achieving our own financial freedom, it is important for us to understand and know ROI better.

Power of compound ROI

Table 1 shows the compounding effect of RM100,000 invested at different compound ROI compounded over 36 years. From the table, we see that differences in ROI that may appear moderate in the short-term can, with compounding, multiply into very large differences in the long term.



For example, if you don't do anything with your saving which earns about two per cent ROI then. your RM100,000 will multiply by two times to RM204,000 after 36 years. If you transfer the money into fixed deposit, you may earn about four per cent ROI and multiply your RM100,000 by four times to about RM410,000. If you grow your money at eight per cent ROI your RM100,000 will multiply by 16 times to about RM1,597,000. With a slight increase of your ROI from two to eight per cent, you end up having a huge difference of RM1,393,000. (1,597,000 - 204,000). If you grow your money at 15 per cent ROI, your RM100,000 will multiply by 153 times to about RM15,315,000. Of course, increasing the ROI means you may face higher risk of losing your money.

The price of making a mistake

Most people fail to realise the high rate of ROI required to make up for money lost in investment. For example, if you start with RM100 and lose 50 per cent of it, you would have to earn 100 per cent on the remaining RM50 just to get back to where you were at the beginning.

Table 2 shows the ROI required to overcome various losses. The time period is five years, and there are two scenarios: an ROI target of 10 per cent and of 15 per cent.


For example, you plan to increase your money for the next five years with 10 per cent ROI. Unfortunately, instead of getting 10 per cent target return, you ended up with a 25 per cent loss. In order for you to still achieve your original target, you would need to achieve 21 per cent ROI for your money for the next four consecutive years. Now, that's the price you will have to pay for making 25 per cent loss in first year.

Do you think it is easy to achieve 21 per cent for four years continuously? Of course, it is not easy. In addition, you will also notice the spread between the amount of the loss and the required ROI over the next 4 years widens as the magnitude of the loss is increased. The larger the losses, the more difficult it is to overcome. I believe you now understand why the first rule to investing, according to Warren Buffett, is "Never lose your money".

Inflation-adjusted ROI

Our money is subjected to the depletion of inflation. Therefore, to effectively grow our money, we need to attain an ROI higher than the inflation rate.

For example, if the inflation rate is four per cent, the 3.7 per cent interest rate for your fixed deposit will not help your money grow. In fact, in the long run, you lose your money safely. In this case, the inflation-adjusted ROI is actually -0.3 per cent (3.7-4).

Therefore,to grow our money, we need to seek inflation-adjusted ROI.

To achieve financial freedom, you have know what rate of ROI you actually need.There is an optimum ROI rate to target and achieve. This optimum ROI rate should be higher than the inflation rate but not too high that will risk losing money.

Therefore, the challenge for all of us who want to achieve financial freedom is to find out what that ROI is? Do you know what is your optimum ROI? If not, it is always better to find out earlier than later.


Yap Ming Hui is the managing director of Whitman Independent Advisors Sdn Bhd, the first multi-client family office in Malaysia.

http://www.nst.com.my/Current_News/NST/Sunday/Focus/2426202/Article/index_html