June 12, 2019

ROI vs NPV: What Are They and What Do They Mean?

Image of a watch with money to illustrate the "time value of money." This is a key point when looking at ROI vs NPV.
Image by TheDigitalWay from Pixabay

When deciding to buy a new technology or business asset, companies typically evaluate if that investment will “pay for itself” using financial metrics like return on investment (ROI) and net present value (NPV). ROI and NPV matter to both the buyer and seller because they are the foundation of building a business case for the investment. These metrics make it easier to compare investment options that are competing for the given capital and/or operating budgets. So, ROI vs NPV, what exactly are they and what do they tell us?

What is ROI?

Return on Investment is a percentage that represents the net value received from an investment over a given period of time. The ROI formula is easy to remember because it is visually literal: ROI = total benefits minus total costs (return) divided by (on) the total costs (investment).

The ROI Formula

The return on investment (ROI) formula: ROI=Total Benefits-Total Costs/Total Costs.

For example, if your company invests $400k in a technology and realizes profits from that investment of $1M over a three-year period (through cost savings, employee efficiency, or incremental revenue), then the three-year ROI of that investment is ($1M – $400k) / $400k = 150%.

ROI is simplistic. It tells how profitable an investment is over a given period of time. It’s a useful metric, but due to its simplicity, it doesn’t tell the full story.

One of the most significant drawbacks of ROI is that it doesn’t consider the time value of money. You might calculate a five-year ROI of an investment to be 30% and feel that is strong enough to take forward to management. This may be true if the one- or two-year ROIs are positive, but if positive ROI doesn’t occur until year four or five, then this may not be a wise investment.

So, what is a good ROI? Generally, I like to see a five-year ROI closer to (or exceeding) 100% when providing our ROI analysis service. That way I’m fairly certain the value will hold up if converted to today’s dollars. Which is the perfect segue to net present value (NPV).

What is NPV?

As simple as ROI is, NPV is complex, so grab a cup of coffee and don’t get too comfortable.

Net present value (NPV) is commonly used by technology and business asset investors because it converts the multi-year benefits and costs of an investment into today’s dollars (or other currency value). This makes it easier to compare investment options. Investors can look at this “normalized” value along with other factors (like strategic importance and risk) when making decisions.

The conversion to today’s dollars is accomplished by doing a discounted cash flow analysis, whereby the multi-year benefits minus costs are “discounted” with a “hurdle rate.” Hang with me here, I will explain … with an example. The hurdle rate is commonly the firm’s risk-adjusted weighted average cost of capital (WACC).

Said differently, companies are continuously making decisions on how to manage their money. For example, they may need to decide between:

  • Reducing debt, which essentially yields a return based on their interest rate;
  • Investing in their own stock;
  • Hiring more employees (to generate a targeted profit per employee) or;
  • Buying technology to drive efficiencies.

In order to level the playing field regarding riskier options (like acquiring a business or technology), companies establish an expected annual financial return percent (or hurdle rate). Projections for a proposed investment must exceed the hurdle rate to be viable.

We go through a similar “analysis” when we make decisions about our own money and assets. We consider the strategic importance to our quality of life of buying a house or car. Then we couple that with financing options based on the interest rate, cash availability, and whether we can do better in the market. On a periodic basis, we make adjustments. If we get a bonus, we may buy down our mortgage because that interest rate is higher than the interest rate on our car and less risky than buying stock.

Having delivered a number of sales trainings, I can tell you that NPV (and the associated hurdle rate) is one of the more challenging financial concepts. It doesn’t help that the formula includes a Greek symbol, allowing students to confirm that it is literally Greek to them.

The Net Present Value Formula

The net present value (NPV) formula.

Some of you are saying, “kill me now,” right? Fortunately, Excel makes this easy for us after you overcome the concept of compounded rates. Let’s look at an example.

Assume a company invests $500K in a technology and nets value of $150K in year one and $400K in years two through five. Here’s how the NPV could be calculated.

NPV Calculation Example

Net present value (NPV) calculation example.

You’ll see that we used 10% as the placeholder discount rate (hurdle rate), knowing we can update it later with the company’s actual rate. Using 10%, we can calculate the “discount factor” for each year. To discount the cash flows, we divide the cash flow for each year by its discount factor. For year one we divide by 1.1. In year two we divide cash flow by 1.21 (1.1 x 1.1 = 1.21). In year three by 1.331 (1.1 x 1.1 x 1.1) and so on. All we’re doing is discounting the value for each year by 10%. As we go into the future, we add another 10% discount each year.

What you should see is that the $400K keeps shrinking when converted to today’s value. If you made it this far and to that conclusion, great! You can always leverage your internal financial guru, or even TFP to help with the math.

So, what is a good NPV? Any positive number—no joke—if a company has set their hurdle rate correctly, and the analysis is performed with credible rigor, then any value greater than zero means that an investment is a viable candidate. Of course, a $1 NPV may be appropriately challenged by an NPV in excess of $1M which is why business case analysts will diligently work to include as many credible benefits as possible to yield a higher value. Conversely, if the NPV is negative, the investment should not be made.

Like ROI, avoid using NPV in a vacuum. Combine the metric with other considerations like strategic importance and risk (including the magnitude of the cost). What’s great about NPV, though, is that it factors in time value of money and a company’s hurdle rate—all in one calculation!

If you want to see NPV in practice, my colleague, Alex Corman, does a nice job of illustrating NPV in his white paper, “Calculating ROI for Technology Investments.”

What is the Difference Between ROI and NPV?

To summarize, ROI is a simple calculation that subtracts total costs from total benefits and then divides that net value by the total costs. The result is a percent that can give you quick insight into how much greater the net value of the investment is when compared to the costs.

NPV takes the same total costs and benefits but more closely considers when they occur. Then it converts them into today’s currency values by discounting them by the company’s hurdle rate. The calculation for NPV is more complex than the calculation for ROI, as it considers the time value of money and a company’s minimum expected return. As a result, however, NPV provides greater insight when comparing investment options and making go-no-go decisions. Remember, NPV only needs to be greater than zero to make an investment a viable option.

Both ROI and NPV are dependent upon the time duration for the given analysis. This is why the result is typically stated as a three-year ROI or five-year NPV.

ROI vs NPV: Why Do They Matter in B2B Sales?

When considering a technology investment, the financial buyer will want a business case analysis (aka ROI analysis) that includes a multi-year view of cash flows (costs and benefits) as well as key financial metrics. We recommend including the ROI and NPV metrics as well as the payback period. B2B sales representatives will want to allow time for this process, pulling in their ROI analyst or tapping into third-party resources that provide ROI on Demand services.

In some cases, a financial buyer (CFO) may insist that they need a 12-month ROI. While this isn’t technically accurate, what they’re saying is that they want the first-year value to be greater than first-year costs. They’re more talking to payback, but it’s probably not worth the argument (let the customer be right, right?). In some cases, you can use extended payment terms to achieve this type of short-term goal.

If you made it this far, you deserve more than a cup of coffee! I hope this helped. As always, feel free to contact TFP with your ROI related questions.