ROI and Payback Period

Investors want to make money on their investment. But how much expected return is enough, and how do they measure it? With an investment performance metric.

ROI

Most of us know ROI, Return on Investment. It's easy:

ROI = (Money Back − Investment) ÷ Investment

Invest $10,000 and get back $12,000: your profit is $2,000 and your ROI is $2,000 ÷ $10,000 = 20%. ROI is always a percentage.

Say you're a VC with two startup opportunities, each projecting an ROI of around 50%. Not too shabby. Which one do you do? Neither, at least not yet. A VC needs to expect much more than 50% from a startup. Most startup investments lose all their money, so the few that do well have to make up for all the problem children.

Now let's turn the dial up to Spinal Tap 11. Crazy Paul is dealing. I offer you a guaranteed, legal deal: invest $10,000 and get back $200,000. That's twenty times your money, an ROI of 1,900%. Do you do it?

If you said yes, I've got some bad news. You'll get all $200,000, but in 50 years.

That's the problem with ROI: it tells you how well an investment did, but not how soon. Sometimes ROI is enough: if you expect to put in $10,000 and get back $8,000, it doesn't matter when; you don't do it. But when you expect to make money, ROI alone can't tell you whether to invest.

Payback Period

Payback Period is simply how long it takes to get your money back. Invest now, get it back in two years: the Payback Period is two years.

Sometimes that's all you need. Say you need your money back in 18 months, and someone offers an amazing deal: over 200% ROI in two years. Doesn't work: the Payback Period is 24 months. But if the Payback Period is fine, is that enough? No. It tells you when you get your money back, not how much profit you'll make.

To sum up: ROI tells you how much but not when. Payback Period tells you when but not how much. Can we combine them? Indeed we can.