Join Rudolph Rosenberg for an in-depth discussion in this video Understanding return on investment (ROI), part of Making Investment Decisions.
As we have seen every investment is expected to deliver a return. I'd like to take some time now to discuss in more detail, what we mean by return. The word return is usually understood as a positive return. Meaning that it is bigger in value than the capital originally invested. The definition of a return is actually broader than that. And does not always mean it is positive. You can have positive as well as negative return, or no returns at all. If what you get from your investment is equal to the capital invested, then you're not making any return.
If it's higher than the capital, then you're making a positive return. If you're getting a lesser amount than the original capital, you're making a negative return. The return is the difference between what you invested, the capital. And what you're getting back from your investment. Lets take a concrete example to illustrate this. Let's say you're investing $1,000 into a project, and get back from it $1,100 in one year. The difference between the $1,000 capital and the resulting $1,100 is $100.
This is the return you have made. Usually, returns are displayed in percentages per year. So in our example, because we have generated $100 in one year for a starting capital of $1,000. We can say that a 10% return per year has been generated. The formula to calculate the return in percentage for a one year investment, is the following. Return divided by capital.
You can also calculate it by taking the end value, divided by capital, minus one. Those two formulas provide the exact same result. For our multi-year investment, the formula is a bit different. You first have to calculate the end value divided by the capital. And then you have to take it to the power of one divided by the number of years. You take all of that, and do minus 1.
To illustrate the multi-year formula, let's assume that investment happened over the course of two years instead of one. Then, we will have calculated the return percentage in the following way. First, divide 1,100 by 1,000. Take this result and put it to the power of 1 divided by 2, which is the number of years. Take this result, minus 1, is equal to 4.9%.
So this investment is producing over the course of one year, a 10% return. But if it is producing its return over the course of two years, then it's an average of 4.9% return per year. If we take back now the one year example, but assume we are getting back $900 in the end. Our return becomes then a loss of $100. In percentage terms, this becomes a minus 10% return, it is a negative return.
$900 divided by $1,000, minus 1 is equal to, minus 10%. Now let's put one thing out of the way right now. A positive return, is not sufficient by itself to qualify as a good investment. This is a shortcut that is commonly made. But other factors need to be taken into considerations. Such as other options available to you, for example.
This course teaches the net present value (NPV) methodology, an investment evaluation formula used by countless publicly traded companies and financial analysts, in a way that makes it accessible and applicable to you—no finance background required. Rudolph Rosenberg explains what investments are, how they are measured, and what makes a good investment. Then he explores the NPV formula in depth, showing you how to evaluate your cash flows, choose a rate of return, and assess the risk of a particular investment. This all culminates in a look at how the principles of investment apply to three real-life scenarios that any individual or company might encounter.
- What is an investment?
- Understanding ROI
- What makes a good investment?
- Using the NPV formula
- Assessing risk
- Applying NPV to real-life situations