The Types of ROI and Which One to Use

Posted 12-04-2014 11:27 am by

Did you know that there are different types of Return on Investment, or ROI for short?  Each one has a different purpose and tells you something different about the investment you are considering making.  Understanding the different types of ROI is essential to being a savvy investor - whether you are buying a business, acquiring rental property, or deciding which business opportunity to pursue. 

ROI #1: The yield

The most basic return on investment is called the yield.  If you put $10,000 in a savings account and get $100 per year in interest, the yield is simply $100 / $10,000, or 1%.  If you purchased a piece of commercial property for $5,000,000 and the net operating income is $250,000 per year, the yield is $250,000 / $5,000,000, or 5%.  If you buy a business for $500,000 and it cash flows $100,000 a year, the yield is $100,000 / $500,000, or 20%. 

Notice that when we are calculating the yield, we are simply taking the net income produced divided by the purchase price.  In other words, we are assuming an all cash purchase.  If an investor were to pay all cash, this is how much income the investor would receive.  The yield is quick to calculate, and is a useful tool to get a quick glance of the relative returns of various investment options.

ROI #2: The cash-on-cash return

When buying a business, apartment, or commercial real estate, it is common for the buyer to obtain financing.  Not paying all cash lowers the income the buyer receives (since the buyer now has the added expense of a mortgage payment), but the initial cash outlay is also lower.  The cash-on-cash return, or CCR, compares the amount of cash coming in with the amount of cash going out. 

Let’s take the example of the business that sells for $500,000 and cash flows $100,000 a year.  If the investor pays all cash, the cash-on-cash return would be the same as the yield - $100,000 per year of cash coming in, $500,000 of cash going out, giving us a CCR of 20%.  However, let’s suppose the investor only puts $100,000 down and borrows $400,000 from the bank.  Let’s also suppose the mortgage payment is $30,924 per year.  The cash coming in is now reduced from $100,000 a year to $69,076 (taking $100,000 - $30,924).  The cash going out, instead of the entire $500,000, is now just $100,000.  Taking the cash coming in divided by the cash going out, we get $69,076 / $100,000, or a cash on cash return of 69%. 

As you can see, getting financing at favorable rates can dramatically boosts one’s cash-on-cash return.  Conversely, getting financing at high interest rates could produce a cash-on-cash return that is lower than the yield.  Many investors like using the cash-on-cash return because it describes the relationship between how much cash they actually put up, and how much cash they actually receive. 

ROI #3: The net present value

The net present value, or NPV, is often used by major corporations when making important financing or merger and acquisition decisions.  The basic idea behind the net present value is that money received today is worth more than the same amount of money received in the future, because you can invest the money (and thus generate returns) if you were to receive the money today. 

Let’s take the example of receiving $10,000 today vs. receiving $10,000 two years from now.  Let’s also suppose that your plan is to simply put the money in a high-yield savings account that pays 1% a year in interest.  If you were to receive $10,000 today and you leave it in the bank for 2 years, you would end up with $10,100 at the end of year 1, and $10,201 at the end of year 2.  In other words, receiving $10,000 today is better than receiving $10,000 two years from now.  How much better?  Well, if your plan is to put it in a savings account that pays 1% a year, receiving the money today would be exactly $201 better than receiving the money in two years. 

Now here’s another question.  Suppose Tom offers to pay you $10,000 today, and Sally offers to pay you in 2 years.  How much would Sally need to pay you in 2 years in order for Sally’s offer to be equally attractive to Tom’s offer?  In our example above, we determined that receiving $10,000 today is equivalent to receiving $10,201 in 2 years assuming you make 1% interest on your money.  In other words, you can work backwards to determine that receiving $10,201 in 2 years is the same as receiving $10,000 today, given that you invest the money in the meantime at 1% interest. 

Calculating the net present value requires projecting the cash flow for a number of years into the future, and then working backwards to determine how much that cash flow is worth today.  If you have an investment that cash flows $30,000 in year 1, $50,000 in year 2, $60,000 in year 3, $80,000 in year 4, and you sell the investment in year 5 which gives you a cash inflow of $250,000, you can work backwards to figure out how much $30,000 received a year from now is worth today, how much $50,000 received in 2 years is worth today, how much $60,000 received 3 years from now is worth today, how much $80,000 received 4 years from now is worth today, and how much $250,000 received in 5 years is worth today.  Finally, you add up the “present value” of all the future cash inflow, the total of which is hopefully a large positive number.  You also have to put up some cash to buy the investment.  Taking the total present value of the future cash inflow minus the cash outflow today gives you the net present value of the investment. 

The NPV is perhaps the most comprehensive method in determining the return on investment, because you are taking into consideration years of projected cash flow - often through the eventual sale of the asset.  You are also taking into consideration the opportunity cost.  If an investor can make 1% return by putting the money in the bank, Tom’s offer of $10,000 today would be equivalent to Sally’s offer of $10,201 two years from now.  However, if you can make 5% return on your money, Sally would have to pay you $11,025 two years from now in order for her offer to be equivalent to Tom’s offer of $10,000 today.  The downside of NPV is that it is more complicated to calculate, and the resulting value varies depending on the discount rate chosen.  The NPV is also a dollar amount rather than a percentage, and many investors would prefer the rate of return expressed as a percentage. 

ROI #4: The internal rate of return

The internal rate of return, or IRR, is a way of turning the NPV into a percentage.  In fact, the definition of IRR is the rate of return in which the NPV equals zero.  The IRR has all the benefits of the NPV method with the added advantage of expressing the result as a percentage rather than a dollar amount. 

Given its advantages, many investors prefer to use the IRR over the NPV.  It is worth noting, however, that there are times when the IRR and NPV give conflicting results.  For instance, let’s take the example of a commercial building owner who is considering installing solar panels on the roof.  Installing solar panels would reduce the electricity costs every month, which translates into an increased bottom line.  It’s almost like having a NNN tenant sitting on the roof that pays the owner a stream of cash flow every month for years to come.  To acquire this “NNN tenant”, the owner would need to buy the solar panels.  In other words, we have a cash outlay today, followed by a stream of cash inflow for years to come, allowing us to calculate the NPV and IRR. 

Now let’s suppose the owner decides to enter into a power purchase agreement (PPA) for the solar panels instead of buying the solar panels.  There are companies that would buy the solar panels for you, install it on your roof, and enter into a long-term contract that shares the electricity savings with you.  In other words, would you rather put up $300,000 upfront and save $500 a month in electricity costs by buying the solar panels yourself, or would you rather put up nothing and save $100 a month in electricity costs (the remaining $400 goes to the company that bought the solar panels and placed it on your roof)?  If you buy the solar panels yourself, you would get the higher NPV.  If you enter into a power purchase agreement, you would get the higher IRR (since you put up nothing and thus have an infinite internal rate of return). 

In summary, there is a time and place for each type of return on investment.  Knowing when to use each measure to calculate one’s returns allows one to make solid investment decisions. 

Aaron Muller has sold over 120 companies and facilitated over 40 SBA loans for his clients. Contact Aaron at (425) 766-3940 to inquire about buying or selling a business.

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