Eromosele Abiodun highlights the misconceptions about return on investment and examined other factors such as return on asset, return on equity annual or annualised rate of return
The first thing that comes to the mind of an average investor is the possibility of reutilising a 100 per cent return on his investment. How this could be achieved is not his immediate worry.
This, analysts said, is as a result of the low level of investor education in our clime. While some investors know that getting adequate return requires time and hard work on the part of the company they have invested in, others believe investment in the capital market is all about capital gain. Rate of return or return on investment (ROI) can be achieved in three different ways. They include: dividend payout, bonus issue and capital appreciation.
Conversely, bank accounts offer contractually guaranteed returns, which make it impossible for investors to lose their capital. Depositors lend money to the bank, and the bank is obligated to give them back their capital plus all earned interest. Meanwhile, THISDAY findings revealed that 65 per cent of investors in the Nigerian capital market invest with the hope that the price of their stock appreciate by a 100 per cent or more in one week. Only a few investors actually invest for bonus and dividend.
Market watchers said this situation was largely responsible for the unstable trend in the Nigerian capital market. Expectedly, during the government-induced recapitalisation and consolidation in the financial service sector, in 2005, smart managers of quoted companies took advantage of this weakness to woo investors into buying their shares. The fall back is the loss of confidence in the market and by extension the bear market witnessed in recent years.
ROI In finance, ROI is the ratio of money gained or lost (realised or unrealised) on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The money invested may be referred to as the asset, capital, principal, or the cost basis of the investment. It is usually expressed as a percentage rather than a fraction. Experts believe ROI does not indicate how long an investment is held. However, ROI is usually stated as an annual or annualised rate of return, and it is most often stated for a calendar or fiscal year.
ROI is used to compare returns on investments where the money gained or lost or the money invested is not easily compared using monetary values. For instance, a N1000 investment that earns N50 in interest generates more cash than a N100 investment that earns N20 in interest, but N20 realised on N100 investment is a higher return on investment than N50 realised on N1000 investment (that is, N50/N1,000 = 5 per cent ROI and N20/N100 = 20 per cent ROI). When considering a continuous process of gaining or losing money with a constant rate of return, the annual rate of return is any value above zero.
Profitability Ratios Profitability ratios typically used by financial analysts to compare a company's profitability over time or compare profitability between companies include: gross profit margin, operating profit margin, ROI ratio, dividend yield, net profit margin, return on equity, and return on assets.
During capital budgeting, companies compare the rates of return of different projects to select which projects to pursue in order to generate maximum return or wealth for the company's stockholders. Companies do so by considering the average rate of return, payback period, net present value, profitability index, and internal rate of return for various projects.
A return may be adjusted for taxes to give the after-tax rate of return. This is done in geographical areas or historical times in which taxes consume a significant portion of profits or income.
The after-tax rate of return is calculated by multiplying the rate of return by the tax rate, then subtracting that percentage from the rate of return. For example, a return of 5 per cent taxed at 15 per cent gives an after-tax return of 4.25 per cent (that is, 0.05 x 0.15 = 0.0075; 0.05 - 0.0075 = 0.0425 or 4.25 per cent). A return of 10 per cent taxed at 25 per cent gives an after-tax return of 7.5 per cent (that is, 0.10 x 0.25 = 0.025 and 0.10 - 0.025 = 0.075 = 7.5 per cent).
Computing ROI Analysts' opinions are divided on how a definite solution could be reached in an attempt to calculate ROI. But a frontline stockbroker and Managing Director and Chief Executive Officer, Emerging Capital Limited, Mr. Chidi Agbapu, believe the first point to note is that the initial value of an investment does not always have a clearly defined monetary value.
"But for purposes of measuring ROI, the initial value must be clearly stated along with the rationale for this initial value. The final value of an investment also does not always have a clearly defined monetary value, but for purposes of measuring ROI, the final value must be clearly stated along with the rationale for this final value. The rate of return can be calculated over a single period, or expressed as an average over multiple periods, " he said. Comparing rates of return, he noted the arithmetic and logarithmic returns were not equal, but were approximately equal for small returns.
"The difference between them is large only when percentage changes are high. For example, an arithmetic return of +50 per cent is equivalent to a logarithmic return of 40.55 per cent, while an arithmetic return of -50 per cent is equivalent to a logarithmic return of -69.31 per cent. "Logarithmic returns are often used by academics in their research. The main advantage is that the continuously compounded return is symmetric, while the arithmetic return is not: positive and negative percent arithmetic returns are not equal," he explained.
Geometric Average Rates of Return
Agbapu further said that both arithmetic and geometric average rates of returns are averages of periodic percentage returns. "Neither will accurately translate to the actual naira amounts gained or lost if percentage gains are averaged with percentage losses. A 10 per cent loss on a N100 investment is a N10 loss, and a 10 per cent gain on a N100 investment is a N10 gain. When percentage returns on investments are calculated, they are calculated for a period of time not based on original investment, but based on the amount in the investment at the beginning and end of the period.
"So if an investment of N100 loses 10 per cent in the first period, the investment amount is then N90. If the investment then gains 10 per cent in the next period, the investment amount is N99.00. A 10 per cent gain followed by a 10 per cent loss is a 1 per cent loss. The order in which the loss and gain occurs does not affect the result.
"A 50 per cent gain and a 50 per cent loss is a 25 per cent loss. An 80 per cent gain plus an 80 per cent loss is a 64 per cent loss. To recover from a 50 per cent loss, a 100 per cent gain is required. The mathematics of this are beyond the scope of what I can tell you now, but since investment returns are often published as "average returns", it is important to note that average returns do not always translate into naira returns," he stated.
Annual and Annualised Returns On his part, Managing Director and Chief Executive Officer, Vintage Capital Limited, Mr. Idowu Ogedengbe, warned that care must be taken not to confuse annual for annualised rates of return.
According to him, "An annual rate of return is a single-period return, while an annualised rate of return is a multi-period, geometric average return. An annual rate of return is the return on an investment over a one-year period, such as January 1 through December 31, or June 3rd 2012 through June 2, 2013. Each ROI in the cash flow is an annual rate of return.
"An annualised rate of return is the return on an investment over a period other than one year (such as a month, or two years) multiplied or divided to give a comparable one-year return. For example, a one-month ROI of 1 per cent could be stated as an annualised rate of return of 12 per cent. Or a two-year ROI of 10 per cent could be stated as an annualised rate of return of 5 per cent."
Potential Cash Returns Ogedengbe agreed that investments generate cash flow to the investor to compensate the investor for the time value of money. He added that except for rare periods of deflation where the opposite is true, a naira in cash is worth less today than it was yesterday, and worth more today than it will be worth tomorrow.
"The main factors that are used by investors to determine the rate of return at which they are willing to invest money include: estimates of future inflation rates, estimates regarding the risk of the investment (e.g. how likely it is that investors will receive regular interest/dividend payments and the return of their full capital) and whether or not the investors want the money available 'liquid' for other uses.
"The time value of money is reflected in the interest rates that banks offer for deposits, and also in the interest rates that banks charge for loans. The 'risk-free' rate is the rate on Treasury Bills, because this is the highest rate available without risking capital, " he said. He added: "The rate of return which an investor expects from an investment is called the discount rate. Each investment has a different discount rate, based on the cash flow expected in future from the investment. The higher the risk, the higher the discount rate (rate of return) the investor will demand from the investment.
"Compound interest or other reinvestment of cash returns (such as interest and dividends) does not affect the discount rate of an investment, but it does affect the annual percentage yield (APY), because compounding/reinvestment increases the capital invested. For example, if an investor put N1000 in a 1-year Certificate of Deposit (CD) that paid an annual interest rate of 4 per cent, compounded quarterly, the CD would earn 1 per cent interest per quarter on the account balance."