Broaden the Concept of Return on Investment (ROI)
I was talking to a friend and former co-worker the other day about a recent major acquisition in the finance industry. One large company in this industry had financial trouble of its own in the last few years, received an infusion of capital to keep it afloat for a while, and began selling off its divisions. Another financial company purchased one of these divisions for what seemed like a deeply discounted price.
My friend believed the acquiring company overpaid because an investment of a certain amount of money should reflect a certain amount of expected annual revenue, and according to his calculations, the division could not be earning the revenue that would make the purchasing price a good move. This friend is just an observer and may not be aware of certain insider details, but he was analyzing the potential return on investment (ROI) for the acquiring company, or at least repeating what other analysts had been saying publicly.
Any financial decision deserves an analysis of ROI. For example, if you are shopping for a rental property, you can compare purchasing options by calculating your expected rate of return. For each property, your down payment and other initial expenses total your investment, and your expected net income after operating expenses, mortgage payments, and taxes is your total profit. Divide the profit by your investment for your rate of return on each property, and look for the best investment.
This is a personal finance blog, so there is a tendency to look at life through the eyes of someone obsessed with personal finance. It’s easy to forget that profit is not the motive for everything we do in our lives. A popular argument is to look at the tuition and other expenses you pay for a college education as an investment with an expected financial return.
It’s easy to use the ROI model and come to the conclusion that many private four-year bachelor’s degree programs are not worth the “investment” when considering your salary growth when compared to state programs. ROI is also used when people determine that a college education is worthwhile if it sets you apart from others in your field; an investment banker with a four-year degree will earn more after spending $100,000 on their education than a musician who paid the same amount to attend the same school.
If return on investment were the only consideration, everyone would go to the least expensive college to earn a degree in the most lucrative field. The country would be filled with engineers and investment bankers, After a while, however, the laws of supply and demand would spring into action, and more competition among graduates would drive down the “market price” for these professions. Regardless of what the prevailing top-earning profession of the day is, everyone who had the mental capacity to do so would chase that job and do so from the least expensive school.
The choice of a starting path for your life through a career should not be based on ROI. It is beneficial to be aware of what your finances might look like, and most people would want to make sure they can afford at least the necessities, but there is more than just the hard numbers to consider. Your true return on investment goes beyond the income you’ll earn.
Here are a few things to include when considering you’re complete return on investment. These are all things that are hard to quantify.
- Your human capital. As I mentioned recently, education is one way to boost your human capital. Robert Pagliarini, author of The Other 8 Hours, also explored human capital in this previous podcasts.
- Your experiences. In general, the value of experiences increases over time while the value of things you acquire — and money, thanks to inflation — decreases over time. The value of experiences is perception, but it matters.
- Your mental exercise. I spent my time with some of the most intelligent and talented people while in college, both students and professors. The people I met while pursuing my studies opened doors to meet more amazing individuals — people who are the best in the world at what they do.
While this article is focused somewhat on education, you can look beyond a pure financial ROI for any decision you make. If you are considering a vacation to South America, you do not worry about whether you will recoup your costs.
If you plan on buying a camera, you may plan to earn money from photography, so perhaps your financial return is a consideration. Professional photographers may make purchasing decisions based on whether a new piece of equipment will help them earn more money, but amateurs are looking for the experience and mental exercise portions of the total return on investment.
People who have worked hard to learn about personal finance and investing often try hard to look at everything through a financial lens to the detriment of their ability to see the bigger picture. Financial considerations should definitely be part of any decision involving money, but you must not limit yourself to the numbers.
Photo: cogdogblog, Zoe_Q
I know it wasn’t the point of the post, but to return to the initial example, it still can make sense for the company to sell up now rather than wait several years for those plans to come to fruition.
Why? Firstly because of the time value of money, which basically means a bird in the hand is worth two in the bush! (The money can immediately be reinvested, etc).
Secondly, there’s a risk that those future plans won’t come to fruition because of execution risk or unknown factors. This risk entails a discount to the purchase price.
Just saying! 😉
ROI is the model for everything anymore. What can I get for what? I don’t care whether it is a pair of socks we are purchasing. There is probably a review somewhere that will tell you which are the prettiest and which are the most durable.
I am in the restaurant biz. It is insane the discounting that is going on. I don’t see a great return on any of it. After franchisees lose their respective asses giving away everything the people will diminish when the price accurately reflects the mark up that is neccessary to make a PROFIT.
I can only speak from that perspective unfortunately. So, I say to any restaurant type folks popping in on this great blog…Your ROI is in your people. Your staff. If you train them well and have an expectation that creates an awesome aptmosphere then your return will be better then two people dine for 20 bucks.
That is all.
From a purely financial point of possibly the largest irresponsible ROI decision is to have children. They drain significant costs from us over most of our lives, with little real financial return (even if they offer or we are willing to accept). Still, that didn’t stop me and hopefully many others from recognizing the non-financial ROIs they provide.
Another ROI that is difficult but not impossible to compute are investments made to avoid future cost. Permanent solutions that eliminate future cost (i.e. Dental Implants for someone with poor “teeth genes”) can reduce recurring cost many years in the future. Going to the premier school usually adds bucks later in life but investing in cost avoidance can pay dividends as well. (I probably should have used an example that doesn’t make people cringe, but, what-the-heck.)
If we are talking about education and its ROI then we need to calculate the cost of education. I am sure this is not easy because only a portion of cost of education is tangible. The mosy that we spend on education like fees, lodging, fooding, travel, training, projects, miscellenous expenses can be quantified in terms of money.
But how will you evaluate the money contribution of the brand name of the college, know-how and skil of the professors, contribution of the group (friends) with whom you study etc. May be these intangibles contribute more to your future-growth that the books themselves.
My pay cheque is neither good nor bad, its fair. I have completed my engineering some ten years back form one of the most average college. But fortunately I studied with a group of extraordinary friends. I will never be able to calculate the ROI of my college because I will never be able to quantify the contribution of my friends (who I get only because we studied in the same college) in terms of money.
I liked this article. I totally agree with the views of the blogger. We cannot see this world only from the spectacles of ROI.
Can we ever calculate the ROI of our parents?
“Can we ever calculate the ROI of our parents?” No, but if we honor them, with respect, love, and care as they grow older, they might be able to calculate their ROI – spectacles or not 🙂
See, I would argue that it’s exactly *because* of a return on investment that people go to more expensive schools. Perhaps it’s not ROI in the strictest sense, but there is some truth to more expensive schools landing you better jobs. So by paying more for a quality education (and/or the appearance of one) you’re investing in better paying jobs with more opportunities for advancement.
Depending on your career path, the price of the education doesn’t correspond with landing better jobs. That might hold true for investment banker — and if we’re talking about ROI, everyone would be an investment banker — Ivy League gets you in. But not many jobs see that much of an advantage.