In previous articles, we have explored various methods of fundamental analysis, including cash flow and earning. Two key questions every investor asks are — How much will I make from this investment? How soon can I get returns? These questions are broadly Return on Investment (ROI) questions and there are lots of ways to calculate it, including Breakeven Analysis and Internal Rate of Return. Let us look at their ROI tools in detail starting with Payback
Payback is how long it takes for an investment or business to recoup its initial investment. With Payback, the shorter the number, the better. Look at it this way, if you got an offer to build a railway from Lagos to Ibadan and you will get payback in 5 or 8 years, which would you prefer? 5 of course.
Payback analysis is useful where the investor wants to know if the project is work the time and investment capital it is also easy to calculate. A shorter payback also means the project has a shorter time to be exposed to volatility and risk however this does not mean it eliminates risk, it just determines time frame during which the investment is subject to higher volatility without a full return of invested principal. Payback is like Breakeven calculation, but payback is focused on time while breakeven is focuses on time as a unit.
To calculate payback, the cash flow or return from the investment needs to be known. For instance, A company wants to set up an online platform to receive online orders. It estimates the project will cost N5m in total and will increase sales by N1.5m every year. The company projects that the equipment will be depreciated at 20% meaning it will last 5 years. What is the payback for this project?
To calculate payback, we divide the total cash sum by the cash returns for the project. In this case, 5,000,000/1,500,000 that equals to 3.33. Note the company estimated the project equipment will last 5 years
Payback does not talk about profitability, rate of return or if the company investing will remain as a going concern. The calculations are simply focused on when the initial investment is repaid. From the example above, the N1.5 the earned from new project 1.5m is not profit, its cash received because of the new online ordering system. Payback does not also consider Time Value of money, thus again from our example, the Present Value of N1.5M received is not considered. This Payback is often used as a gateway analysis tool to determine if a project should be considered.
To enhance Payback calculations, many analysts will integrate time value calculation with discount rates to match the future cash flows to today’s cash outlay. This is known as Net Present Value (NPV) which is the present value of the cash flows at a discount rate compared to your initial investment. Thus, NPV compares future cash to today’s cash outlay to determine If project is viable. Eg you discount all future dividends from stock using a discount rate back to today and compare it with a market price to determine if you should buy the stock. If NPV is positive, then the project or investment is good, a negative NPV means the future cash flows are worthless, thus not a good investment. The main problem with NPV in my estimation is the assumption of the discount rate to use. A discount rate that too high or low will skew the results of the NPV and render the output false.
The last ROI calculation I want to review is the Internal Rate of Return (IRR). Technically the IRR is the rate of return that makes all cashflows rates of return equal to zero, in other words, it is the rate of growth investment is expected to generate annually. The more positive the better. IRR integrates the elements of payback and NPV and is also use in comparing different options and picking the option with the highest value.
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Today, all these formulas are available on Excel sheets and financial calculators on our mobile devices you do not have to be a math’s geek to implement ROI, but I remain a useful tool in comparing projects.