Business, Legal & Accounting Glossary
ROI (Return on Investment) is the premium an investor receives for investing in a company when he liquidates his holdings. Private equity investors express their return expectations in terms of percentages, much the same way lenders price their loans. By determining what compounded annual rate of return he wants from a given investment, an equity investor can then work with his projections for the company’s growth to arrive at the percentage of the company’s stock he needs to receive in order to reach his desired return
Return on investment (ROI) is a method of calculating profits from an investment. The gain is converted to a percentage to facilitate uniform comparison. The usual formula is 100 X gain/cost. The number is useful for comparing the performance of investments and resembles the yield paid on fixed-income investments like CDs.
The time period used for the calculation can vary, but the most common one is for the calendar year or the fiscal year.
When stock investments are compared it is common to calculate the gain as the difference between the closing value for a recent date and the closing value for one year earlier. When dividends have been paid or distributions from a mutual fund, they are added to the gain.
In some cases, the cost is adjusted by subtracting depreciation or other allowances like depletion.
A negative value is reported when the result is a loss.
When the time period exceeds one year, the compound interest formula can be used to calculate the compounded rate of return for the investment.
When calculations are based on single stock prices, the number can vary wildly depending on the particular times chosen to select stock prices. More reliable estimates can be obtained by averaging prices over a specified period or by using curve-fitting techniques such as least squares (regression analysis) to fit a calculated line to a collection of stock prices. Then the slope of the calculated line approximates return on investment.
What ROIs do most venture capitalists require to fund a company? They vary from company to company. The following chart gives some general ranges, based on an economy supporting prime interest rates below 10 percent.
Compounded Annual ROI
|Seed or start-up||35% and up|
|First and second stage||20% to 50%|
|Third stage and mezzanine||15% to 30%|
How these rates of return translate into cost to a company depends in large part on how long it takes the investor to exit. The following table illustrates this fact.
|Three times investment in three years||44%|
|Five times investment in three years||71%|
|Seven times investment in three years||91%|
|Four times investment in four years||41%|
|Three times investment in five years||25%|
|Five times investment in five years||38%|
|Seven times investment in five years||47%|
|Ten times investment in five years||58%|
Compound interest formula
Fixed income investments
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This glossary post was last updated: 29th November, 2021 | 0 Views.