Negative ROI means a loss on investment and it may occur due to several reasons. It is also presented in a percentage term and the formula to calculate is the same as for (positive) ROI.
Let’s dive in to know more about negative ROI.
What is Return on Investment (ROI)?
Return on Investment (ROI) is the measure of gain or loss with an investment. It compares the probability of an investment outcome against the total cost of investment.
Simply put, ROI is the measure of gain or loss arising from a project, business, or investment.
If the return exceeds total costs, it will show a positive ROI. Else, if the return is less than the total costs, it will show a negative ROI.
In other words, when an investor makes money (gains) it is a positive ROI and when an investor incurs losses it will be a negative ROI.
ROI is expressed in a percentage term although it can be expressed as a ratio as well. It can be calculated on annualized terms or for the total term of the investment.
How to Calculate Return on Investment?
We can calculate ROI by using the formula given below.
ROI = Return on Investment/Cost of Investment ×100%
And
Return on Investment = Final Value of Investment – Initial Value of Investment
Here you can see that the numerator of the formula can be a positive or negative figure. Therefore, analysts must ensure to include the full cost of investment and all relevant cash flows for the investment.
ROI is not a time-bound ratio. Therefore, its interpretation also requires careful consideration of the investment term.
That is one reason why ROI is expressed as a percentage term to make comparisons and evaluations easier.
Annualized ROI
Annualized ROI is a useful method to evaluate and compare ROIs from different investments. It can help in comparing more investments with different periods and different outcomes.
The formula to calculate annualized ROI can be written as:
Annualized ROI = [(1+ROI)1/n −1] ×100%
Suppose an investment has an ROI of 30% after 4 years. If we simply divide the return by the average, it gives us an annual return on investment of 7.5%.
However, when we use the annualized ROI formula above:
Annualized ROI = [(1+30%) ¼ – 1)] × 100% = 6.77%
We can see that the actual annualized ROI of the investment is less than the average ROI of 7.5%.
What Does Negative Return on Investment Mean?
Negative ROI means a loss on investment. It happens when the total cash outflows exceed the total cash inflows arising from an investment. There are several causes of negative ROI (detailed below). However, a negative ROI for different types of investment can occur due to various reasons.
Negative ROI for Projects
Projects with a limited timeframe may result in a negative ROI when expected cash outflows exceed cash inflows.
Most often, projects are financed through debt financing. Therefore, a change in the interest rate can cause an unexpected financial outcome.
Also, equipment financing would change when interest rates increase. A change in interest rate would also mean a higher inflation rate.
Combining all these factors means the outcome of a project will show losses. The company may use adjusted ROI or change the cashflows as and when they change to avoid negative ROI though.
Another way to avoid negative ROI on projects is to forecast all relevant project costs correctly. Unrelated costs should be removed from the ROI calculations as well.
Negative ROI for Stocks
Similarly, negative ROI for stocks happens when your actual returns are lower than the anticipated returns.
Stocks can fall in price at any time. Also, companies may not issue consistent dividends. These factors combined may result in a negative ROI of stocks.
Volatile stocks are more likely to result in losses. The risk factor also plays an important role in calculating the return on investment for stocks.
Most often, a dip in the price of the stock due to underperformance of the company and economic conditions is the main reason for losses on stock investments.
Negative ROI for Businesses
Businesses may not come with finite terms as projects. Therefore, calculating ROI for a business is different from calculating the ROI of a project.
Analysts can use the same formula to calculate the ROI of business investment. However, the results will show a negative ROI in the beginning as there will be higher cash outflows than cash inflows.
As the business establishes itself, it will generate higher sales. This will result in higher cash inflows.
Therefore, an established business is more likely to result in positive ROI than a young and growing business.
Working Example
Suppose an investor buys stocks of ABC company at $30 per share. The investor buys 1,000 shares of ABC stock and intends to hold them for 5 years.
ABC company pays a dividend of $ 1.5 per share annually. Suppose ABC stock price falls to $20 per share when the investor sells them after 5 years. The investor also paid a total commission of $200 for both transactions.
Let us calculate the ROI for ABC stocks.
ROI = Net Investment/Initial Investment × 100
Where Net Investment = Final Investment Value – Initial Investment Value
ROI = [{(20 – 30) × 1000 + (1,000×1.5×5) – 200}/30×1000] × 100
ROI = [(- 10,000 + 7,500 – 200)/30,000] × 100
ROI = (- 2,700/30,000) × 100 = – 9.0 %
Although the investor received a healthy dividend of $ 7,500 during these five years, the total ROI remained a negative 9.0% after five years due to a large price slump in ABC stock.
What are the Causes of Negative Return on Investment?
In the simple example above, we can see that the ROI went negative because of the large price fall of the ABC stock. In practice, investors are unlikely to hold stocks for such long until they fall too low.
We can summarize a few major causes of negative ROI for all types of investments here.
Inflation
Inflation is the biggest factor that reduces the net return on investment as it causes costs to rise.
It is particularly important for projects and businesses where there are regular cash inflows and outflows. Project costs may also rise significantly if the inflation rate increases during the project tenure.
Better inflation rate forecasting and cash flow planning can reduce inflation effects and may avoid negative ROI.
Uneven Cashflows
Investment projects with uneven cash flows may result in negative ROI as well. For instance, capital investments have a large initial investment and will return negative ROI in the beginning.
The total ROI of this investment may remain positive though when the project completes.
Wrong Cashflow Forecasts
A common cause of incurring negative ROI is miscalculated cash flow forecasts. Investors often do not include project-specific costs in estimations.
In such cases, when project costs increase in the later stages, the cash outflows overweigh the cash inflows.
Holding Period of Investment
ROI does not consider the investment holding period. For example, an investor may receive an ROI of 30% and another 20% but the holding period for these investments may be three and two years respectively.
Therefore, investors must use annualized ROI and consider the holding period when comparing negative ROIs.
ROI Ignores Risk
Investors need to take higher risks to earn higher returns. ROI is a financial metric that ignores the risk factor.
Therefore, investors must accommodate the risk factor when comparing ROIs of different investment proposals. Also, investment risks may cause negative ROI as well.
