The Ultimate Guide to ROI, Plus 6 Other Measures for Gauging Performance (2024)

ROI, ROE, ROIC … the list goes on. All you want to do is measure your business’sreturns, but instead, you’re drowning in acronyms.

Measuring returns in business is a critical task to ensure the viability and effectiveness ofa project, investment or even the business as a whole. In a recovering economy, usingavailable calculations to monitor operational performance becomes even more critical. Yet,knowing which measures to use — and their associated best practices — canquickly become information overload.

Fear not: We have compiled the top measures for predicting and gauging returns, whetheryou’re analyzing a particular project or the business as a whole. We’ll walkthrough each formula so you can stop floundering in calculation confusion — and startusing a metrics-driven approach to business.

Key Takeaways

• Measuring returns is critical in evaluating potential investments, gauging the successof existing projects and monitoring business performance as a whole. However, it can behard to identify the right calculations for your needs.
• Both total investment returns and going concern returns can provide valuable informationfor your company.
• We break down the formulas for ROI, NPV, IRR, ROE, ROA, ROIC and ROCE — includinghow to use them effectively, examples, and their respective strengths and limitations.

Return Calculations Overview

Before we jump into the formula fun, note that calculations to gauge returns are often splitinto two categories based on their scope: Those that address total investment returns andthose that handle going concern returns.

While each measure has its own purpose, none should be viewed in isolation. Collectively,metrics from each category can provide insight into the entire operational performance of abusiness on a small and large scale.

We’ll dive into calculations for each measure below, as well as what each is used for(e.g., gauging success of a project vs. the business as a whole), and by whom (e.g., byinvestors vs. company managers). Before we do, here’s a snapshot of everythingwe’ll cover, for you to paste on your fridge (or simply reference as you read onward).

Total Investment Return Formulas

ROI

What is ROI?

Let’s start with the bread and butter of gauging returns: return on investment (ROI).ROI tends to be the simplest and most common profitability calculation used to determine theefficiency of investments. The ratio looks at the gain or loss of an investment as apercentage of the cost.

How do you calculate ROI?

While the term is often tossed around colloquially to describe both qualitative andquantitative benefits of an investment, there is actually an official formula for ROI:

ROI = (Net Profit / Cost of Investment) x100

It can also be thought of as:

ROI = [(Final Value of Investment - Cost ofInvestment) / Cost of Investment x 100%>

A positive ROI indicates that the investment is good. The higher the number, the better.

Strengths and weaknesses of ROI

Many of the ROI calculation’s benefits lie in its simplicity. The basic formula iswell-known, standardized, easy to calculate and well-understood, even amongst non-financeprofessionals.

However, its simplicity is also its weakness. ROI does not account for investment risk northe time value of money, which is a major factor in determining the value of an investment.You can mitigate the time issue by using a variation of the ROI formula, called annualizedROI:

Annualized ROI = [(1+ROI)^1/n -1] x 100%
In this equation, n is equal to the number of years for which the investment isheld.

While annualized ROI tends to be more of an investors’ calculation, it can play a rolein your business. Just note that it tends to look at an investment over either a very longtime or in perpetuity.

For example, let's say your company could open a store in location X at some cost, or inlocation Y at a different cost. The annualized ROI equation can help estimate sales revenuein each location, then determine which will make more money in the long run — or getthe initial investment back the fastest.

ROI example

An ecommerce store invests in a $20,000 robot to build out its manufacturing capabilities.Within the first two years of implementation, the robot has earned the company $30,000 byincreasing the number of products the company can create. So, the calculation would be asfollows:

$30,000 - $20,000 = $10,000 (NetProfit)
ROI = (10,000 / 20,000) x 100%
ROI = 50%

Now, the quality of an ROI percentage can be somewhat subjective based on what the company islooking for — however, a 50% ROI is almost inarguably good considering anything above12% tends to be considered excellent.

NPV

What is NPV?

Net present value (NPV) is a popular tool to gauge a potential investment because it takesthe time value of money into account. It calculates the value of projected cash flows,discounted to the present. Because money is worth more today than in the future — dueto inflation and earnings from an alternative investment you could make instead —it’s important to understand the impact of time on a potential investment.

Simply put, NPV calculates the ROI you expect to gain and translates it into today’sdollars to answer the question: Is the stream of future cash flows worth more than ourpresent investment? It addresses the speed of return and factors in risk, two things typicalROI calculations don’t do.

How do you calculate NPV?

The formula to calculate NPV is:

NPV = _t
∑
^{t = 1}R_t(1 + i)^tR_t = Net cash inflow-outflows during a single periodt
i = Discount rate or return that could be earned in alternativeinvestments
t = Number of time periods

If you’re a bit rusty on summation notation, NPV can also be thought of as:

NPV = TVECF - TVIC
TVECF: Today’s value of the expected cash flows
TVIC: Today’s value of invested cash

The aforementioned discount rate adjusts for the risk of an investment opportunity andaccounts for the time value of money, discounting future cash flows back to their presentvalue. Typically, the bigger the risk, the higher the discount rate.

This is the challenge of NPV. It’s the best way to compare competing investments— but only if you can perfectly estimate risk. Imagine you’re a widget maker anda company like Boeing offers you a 10-year contract to make a new kind of widget. Great! Youhave no risk as long as you can perform, so the discount rate is the 10-year Treasury billrate.

On the other hand, let’s say you own a chain of coffeeshops in a given city. You decideit’s time to open shops in a new city. You have a good track record of predictingrevenue in your existing shops, but there’s that unknown of bringing your brand to acity that doesn’t know it. Estimating that risk is challenging. You can look at thecompetition and the socioeconomic makeup of the target city, but there’s also thematter of marketing your brand in a new place. Getting that discount rate right is trickyand comes down to hard-to-measure things like marketing efficacy and brand value.

There are several types of discount rates that tend to play a role in calculating returns.And each involves a different view of risk:

A discount rate is expected to reflect a risk-adjusted rate of return, which a WACC canapproximate if you’ve borrowed or sold equity to fund past projects.

You can calculate NPV through a function in Excel(opensin newtab) and onlinecalculators(opens in new tab). Determining a“good” NPV is relatively straightforward, as long as you trust yourdetermination of risk. A positive NPV dollar amount indicates a worthwhile investment toconsider. A negative number means the investment is not advantageous. The higher the number,the better the investment. And thus you can compare competing projects: the higher NPV wins.In theory, an NPV is “good” if it is greater than zero. Therefore, even an NPVof $1 should theoretically qualify as “good”. In practice though, many companieswill incorporate their own NPV thresholds to ensure it’s worth the effort and risk.

Strengths and weaknesses of NPV

Aside from recognizing the time value of money, NPV is considered useful because you can useit to easily compare investment options of the same size, which fuels smarter, morestrategic decision-making.

However, it has its shortcomings. For instance, NPV provides an absolute figure, not apercentage, so it can’t be used to compare projects of different sizes. It alsoassumes the discount rate remains the same — but discount rates can and do change overtime as project revenue guesses become facts.

NPV example

Let’s say that same ecommerce company from our ROI example now wants to incorporate thetime factor into its robot’s decision-making. The discount rate, in this case usingthe company’s WACC, is determined to be 10%. Cash flow from the investment isanticipated to be $15,000 each year. The time period being examined is the next five years— after that, the bot will likely need to be replaced. Our calculations would be asfollows:

Thus, the NPV equals $36,861.89, which is considered a “good” number becauseit’s positive.

IRR

What is IRR?

Internal rate of return (IRR) is used in conjunction with NPV, though it involves differentvariables. It calculates the percentage rate of return at which those expected cash flows— which we considered with NPV — will result in a net present value of zero.Unlike NPV, which looks for the dollar amounts a given project will earn, IRR focuses on thebreakeven cash flow of a project. The faster you get to breakeven, the better the project isfor the company.

How do you calculate IRR?

0 = NPV = _t
∑
^{t = 1}C_t(1 + IRR)^t - C₀C_t = Net cash inflow during the period t
C₀ = Total initial investment costs
IRR = Internal rate of return
t = Number of time periods

One part of that equation may be bugging you: If we are solving for IRR, why is IRR includedin the formula? IRR is calculated through “trial and error,” so to speak.You’ll use online calculators(opensin newtab), Excel(opens in newtab)or software to plug numbers into the IRR spot until the NPV is equal to zero.

The higher the IRR, the better. Or the higher the IRR on a project, and the greater theamount by which it exceeds the cost of capital, the higher the net cash flows to thecompany.

Strengths and weaknesses of IRR

Despite the complex-looking equation, IRR is considered one of the simpler ways to determinewhether a project is economically viable. It does not require that a company identify thehurdle rate or required rate of return prior to performing the calculation — thoughyou will need to know the cost of capital to gauge whether the IRR is “good.”Instead, the rate of return is simply derived from the underlying cash flow. IRR’svalue also lies in its ability to simply illustrate the risk associated with the investment:Fall below the required return rate, and the project should be rejected; come in above, andit should be considered.

Also like NPV, the IRR method does not account for project size when comparing projects. Italso doesn’t necessarily account for the reality of reinvestment. The calculationassumes that future cash flows can be reinvested at the same rate as the internal rate ofreturn when, in reality, the number generated by the IRR can be quite high — and a tadunrealistic. Especially when you’re doing high-IRR projects, there aren’t manyother projects available in the interim that can earn the same rate of return.

There is also the “multiple IRR” risk. If a project has a nonconventional cashflow pattern (i.e. when at least one future cash inflow is followed by cash outflow), it canresult in more than one IRR result.

For those reasons, IRR tends to be considered a good way to get additional information on aproject — but not useful as the sole determinant.

IRR example

Using the same scenario and numbers as before, let’s find the IRR of the ecommercecompany’s manufacturing investment:

Here is where we start pluggin’ and chuggin’. Manually handling the equationrequires that we guess the IRR and build from there. Let’s try 50%:

Equation

0 = -20,000 / (1 + 0.5)⁰ +15,000 / (1 + 0.5)¹ + 15,000 / (1 + 0.5)² + 15,000 / (1 +0.5)³ + 15,000 / (1 + 0.5)⁴ + 15,000 / (1 + 0.5)⁵

We end up with 6,049.38. Close, but not quite. We need to up the IRR a bit.

… I’ll save you from reading through unsuccessful estimates. Ultimately, aftertrying a few more numbers, our estimates will bring us to an IRR of 69.666%. Our IRR ofabout 70% suggests that the proposed investment will generate an average annual rate ofreturn equal to 70% over the life of the project taking into consideration the amount andtiming of the expected cash inflows and outflows specific to that investment. Consideringthis is significantly higher than the WACC for our hypothetical ecommerce business (10%),this is a good IRR.

Going Concern Returns Formulas

Remember that second category of return calculations? Here we go:

ROE

What is ROE?

Return on equity (ROE) measures the profitability of a corporation in relation to its totalamount of shareholder equity. Essentially, the ratio gauges how good the company is atgenerating returns on the investment it received from its shareholders.

How do you calculate ROE?

ROE is found using the following formula:

ROE = Net Income / Shareholder’sEquity

“Shareholder’s equity” should be a company’s assets minus its debt.

If your company issues cash dividends, note these will impact the net shareholder equity andtherefore influence the ROE figure. When a company pays cash dividends, itsshareholders’ equity is decreased by the total value of all dividends paid. Areduction in shareholder equity translates to a smaller denominator in the equation —which means a boosted ROE. However, note that stock dividends do not affect theshareholders’ equity.

When considering ROE, a general shortcut is that anything less than 10% — includingnegative percentages — is considered poor. Over 15% is a good ROE. A high ROEindicates that a company is proficient at turning equity investments into profits.

However, note that what constitutes a satisfactory ROE is highly dependent on the industrynorm and your company’s peers. Industries like telecom and utilities typically have a low ROE(opens in newtab) (likely due to their high debt levels), whereas hospitals andhealthcare facilities tend to have very high ROE. So a ROE that may seem “good”or “bad” initially could, in fact, be average for the industry.

Strengths and weaknesses of ROE

ROE is considered an effective way to assess a company’s financial returns andefficiency. It provides a snapshot of how effective management is at using investor capitaland producing value. Additionally, you can easily use the metric to compare performanceagainst competitors.

However, ROE can be misleading for several reasons. For instance, by carrying high debtlevels and repurchasing shares, management can increase a company's financial leverage andthus its ROE, but too much of either can produce an unreasonably high ROE that doesn'taccurately represent the company's profitability.

ROE also fails to account for a company’s future potential. A startup will likely havezero or negative net income, even though it has significant shareholder investment. Thiswill result in an ROE of zero, or even a negative.

A company’s accounting practices can manipulate ROE, both intentionally and not.Various accounting caveats like increasing the project life and decreasing depreciationrate, for instance, can render comparison against competitors using ROE a potentiallyuseless exercise.

Lastly, determining shareholder equity isn’t exactly a walk in the park. You need tofirst determine the company’s assets — and accounting for a full roster ofassets can be deceptively difficult. Tangible assets (i.e. physical resources like cash,stocks, bonds and property), are relatively easy to gauge. However, you also have intangibleassets, like your brand, copyrights, patents, trademarks, goodwill and IP. These values tendto be nebulous — which makes it hard to determine them for use in the ROE formula.

ROE example

Our ecommerce company has an annual net income of $1,000,000. Its shareholders’ equityis $5,000,000.

Net Income ($1,000,000) / Shareholder Equity ($5,000,000) = 20% ROE

Though it depends on the industry standard and the company’s peers at the time, thiswould generally be considered a strong ROE.

The DuPont method

When looking into ROE, you’ll likely come across the DuPont method, also referred to asthe DuPont identity, equation, analysis or model. This is an ROE metric, just expanded. Itbreaks apart the components of ROE to determine what drives changes in ROE, or why an ROE isconsidered high or low — helping to negate some of the aforementioned issues with itsleverage sensitivity. The method is:

ROE Formula = Profit Margin x Total AssetTurnover x Leverage Factor

For companies wary of misinterpreting the ROE metric, the DuPont Method can help deducewhether it’s profitability, use of assets or debt that’s driving ROE.

ROA

What is ROA?

Return on assets, or ROA, is a profitability ratio that determines a company’sprofitability relative to its assets. The percentage it provides illustrates how much profita company generated for each dollar of assets invested in the business. It is particularlyhelpful for internal use by managers to measure efficiency, particularly in asset-heavysectors like manufacturing.

How do you calculate ROA?

Calculate ROA by dividing a company’s net income over its total assets:

ROA = Net IncomeTotal Assets

Total assets include all assets the company owns that have current or future economic value(e.g. cash, cash equivalents, accounts receivables, inventory, fixed assets, marketablesecurities, intangible assets and more).

A higher ROA indicates more asset efficiency. A ROA of around 15% would be consideredhealthy, and 20% or higher would be good. However, this may vary by industry: For instance,the Federal Reserve of Saint Louis tracks the ROA of banks(opens innew tab), where the average tends to hover at 1%. Yet, in an industrylike technology, ROAaverages(opens in new tab) are between 10-20%.

Strengths and weaknesses of ROA

ROA is a valuable tool when it comes to comparing the performance of one company to another.Because it calculates a percentage, it can be used to evaluate companies with differentsizes of assets.

The limitations of ROA are similar to those of ROE, primarily lying in the ambiguity ofaccounting methods. Whether purposeful or not, management’s judgements aroundaccounting methods can impact a company’s ROA.

And again, note the difficulty of determining a company’s total assets. Don’tbelieve intangibles have a big impact? Tell that to Apple. Its brand alone is worth $260.2billion.

ROA example

Above, we designated the net income of our ecommerce company as $1,000,000. Its total assetsare calculated to be $7,000,000.

$1,000,000 (Net Income) / $7,000,000 (Total Assets) = 14.29% ROA

Again, the viability of this metric will vary by industry, but this is generally consideredwithin a healthy range.

ROIC

What is ROIC?

Return on invested capital, or ROIC, aims to measure the percentage return that a companyearns on invested capital. The ratio gives a sense of how well a company is using its moneyto generate returns. Boiling it even further down, it's measuring how efficient a company isin generating cash flow from the areas in which it has invested its capital.

How do you calculate ROIC?

The formula for ROIC is:

ROIC = Net Operating Profit After Tax(NOPAT) / Invested Capital

A ROIC greater than the cost of capital means the return of a company's projects exceeded thecost to fund those projects, meaning the company is creating value. On the other hand, ifthe ROIC is lower than the weighted average cost of capital, the business is losing value.

Generally speaking, a company is considered to be a value creator if its ROIC is at least 2%more than the cost of capital; a value destroyer is typically any company whose ROIC is 2%less than its cost of capital.

Strengths and Weaknesses of ROIC

ROIC takes into account the overall return on both equity and debt. This means the impact ofcapital structure on profitability is essentially nullified — allowing us to comparecompanies with different capital structures in a similar industry. It also analyzes theperformance of all invested capital, a trait notably missing from other performancemeasures. It is also considered one of the simpler metrics of which to determine“success” since you simply need to compare it to the company’s cost ofcapital.

While ROIC is very useful, you should only use it to compare companies in the same or similarindustries. Note ROIC is susceptible to significant one-time expenses (e.g., anorganization-wide restructuring) or revenues (e.g., an extraordinary benefit from a currencyfluctuation).

ROIC example

Our hypothetical ecommerce company has an EBIT of $1,750,000 and a tax rate of 30%. Using theNOPAT calculation (EBIT x (1 - Tax Rate)), we come up with a NOPAT of $1,225,000. Thecompany has $8,000,000 in invested capital. Thus:

1,225,000 (NOPAT) / 8,000,000 (Invested Capital) =15.3% ROIC

Since our previously-determined WACC of 10% exceeds our cost of capital by more than 2%, thiscompany is considered a “value creator.”

ROIC: So hot right now

It has taken a curiously long time for the ROIC metric to gain traction. Nobel prizewinnersFranco Modigliani and Merton Miller identified ROIC as a major component(opens in new tab) of value creation anddestruction.And over 30 years ago, Warren Buffet asserted that company heads aren't skilled enough incapital allocation. In 2007, he wrote to shareholders(opens innew tab) that “a truly great business must have an enduring‘moat’ that protects excellent returns on invested capital.”

Emphasis on ROIC has risen in the past decade. In 2015, General Motors placated activist investors by tying compensation(opens in new tab) to a 20% target. GM saidthat beyonda $20 billion cushion, cash upon which it couldn’t earn that return would be handedback to shareholders, leading the Wall Street Journal to tout ROIC as the "hottest metric infinance.” Jamie Dimon, in his 2018 letter to shareholders of JPMorgan Chase, citedROIC as a key measure of value(opensin new tab).

A good ROIC metric means sustainable value creation that is easier to maintain at a highlevel than something like growth. For many, ROIC is a much better alternative performancemetric, as it measures the return on all invested capital, including debt-financed capital.Though metrics like ROE are historically better-known and more frequently used, ROIC looksto be the “metric of the future.”

ROCE

What is ROCE?

Return on capital employed, or ROCE, looks to determine how well a company is generatingprofits from its capital.

That might sound deceptively similar to ROIC. However, ROCE looks at capital employed inrelation to net operating profit, whereas ROIC looks at invested capital in regards to netoperating profit:

How do you calculate ROCE?

Use the following formula:

ROCE = Earning Before Interest and Tax(EBIT) / Capital Employed
Calculate “capital employed” by subtracting current liabilities from totalassets.

Like for ROE, the criteria for an optimal ROCE tend to depend on industry and sector, andattempts to compare between industries likely won’t offer much insight. And again, thehigher the percentage, the better. The key to a great ROCE is consistency. One good yeardoesn’t mean much. Aim for several years of strong ROCE performance to provesustainability.

Strengths and weaknesses of ROCE

ROCE tends to be a good performance metric to consider when evaluating capital-intensiveindustries, like telecom and utilities, since it looks specifically at capital invested.Like ROIC, it captures the monetary return on both equity and debt, making it a good fit forcomparing companies on that plane, even if they have differing capital structures.

For non-capital-intensive industries, ROCE may present a skewed perspective. It counts largecash reserves as part of the capital employed, even though these reserves may not yet beemployed. As such, this inclusion of the cash reserves can actually overstate capital andreduce ROCE.

ROCE example

As previously mentioned, our ecommerce company’s EBIT is $1,775,000. Let’s sayour capital employed is $10,000,000. Using our equation:

1,775,000 (EBIT) / 10,000,000 (Capital Employed) =17.75% ROCE

While highly dependent on industry norms, the long-term average for ROCE across industriesand sectors is around 10%(opens in new tab),rendering this ROCE higher than the average. Note that an excellent ROCE is above 20%.