ROI = return on investment. It’s the very first thing you learn as an MBA. It is also a widely used yet blatantly overrated measure of performance for any investment in a company. In our case ROI has been used over the years to describe the desired percent return on an investment in a leveraged buyout. For example most private equity firms seek to achieve an ROI of greater than 33% per annum on any common equity dollar invested in their portfolio holdings. However, ROI can be used to analyze any investment.
Here’s why I laugh at this folly. People in the business come up to me and ask “What’s the target ROI on your deals?” I reply I don’t have one. Then they look at me funny, think I’m a jerk and ask “Well what’s your ROI so far?” I reply “Infinity”. Now they really hate me. I proceed to explain that the long answer to their first question is that the deal drives the ROI I don’t. The long answer to the second question is I didn’t put up any money for my deals so the return on investment is incalculable, which to say, infinity.
So they go one step further then they ask well what about anybody who HAS invested money in your deals, what was their ROI? So I indeed cite an example. I have a deal now where the investor has been paid 25% cash on cash return for years. That’s nice and and tidy – but wait – we haven’t even cashed out of the deal yet so that’s not the whole ROI by a longshot. But wait again – we already paid the same investor enough in extra dividends to pay back his whole principal investment even without the 25% payment stream. But 25% cash on cash was computed on the original principal – so wait – 25% isn’t really 25% because this guy doesn’t really have any principal investment at risk anymore. What does our investor think his ROI is? Gosh it might be – nearly infinity!
So my point is that well known popular business authors on Amazon throw around the use of ROI as if it meant something. Here’s another example. Business X has a $1.0 Million net profit. Business Y has a $1.0 Million net profit. They do exactly the same thing. The only difference between the two is that Business X is an LLC and pays out most its earnings each year and as a result has only a $1.0 Million net worth. Business Y is a regular corporation and retains its profits and thus has a $10.0 Million net worth. Business X has a 100% ROI while Business Y has a 10% ROI. So does that mean that Business X is the superior investment by tenfold? Hardly. One could make various arguments about the value of the current income to the investor but that would not hold enough water.
