Return on Investment, also known as ROI, is a very useful tool that is frequently misused. This misuse causes catastrophic, yet invisible, damage to profitability. It’s easy to see this invisible damage when a person has zero profit, but when they have a large number, missed opportunities are hard to identify as everything seems fine. I’m going to explore this today with a view to reselling, but the concepts apply in a much broader scope, including the inability for people to walk away from any poor investment decision.
Return on Investment is the expected gain, however this expectation is (often) the theoretical gain from the investment, described as a percentage. It is theoretical whenever the return is variable. If the investment is a fixed and guaranteed one, such as T Bills, then you could say that the ROI is close to certain. The equation is (Net Profit/Total Invested) * 100. Here’s an example:
You buy a Playstation for $200, you can sell it, after taxes and fees for $250. Your ROI would be ($50/$200)*100 for 25%.
The ROI Trap
Savvy investors (or resellers) might have a target ROI that they state meets their criteria. Sometimes this ROI will change based on the speed of sale (IE a fast flip could be OK at 20% but a slow seller more like 50%). This is actually a ballpark version of the Internal Rate of Return (IRR) concept explored here and here. While sometimes a little sloppy, it’s a smart concept.
The trap springs when prices change, and the investor doesn’t adjust with them. They fixate on the original ROI calculation, and refuse to walk away from the deal at less than they had hoped, especially if that means accepting a loss on the transaction. This is what also happens to people who buy a stock based on some advice, or gut feeling, and can’t sell it as they are anchored to the original purchase price and believe it ‘must go up’.
Nobody cares what you paid
If the market decides that the current price for a Playstation isn’t $250 any longer, and is now $190, that is the price. The market doesn’t care that you bought the item at $200, and nobody else does either. The only person that cares about the cost is you, and that focus is what traps many people.
In another example, let’s look at how the IRS views this. Let’s say you bought the following:
- Playstation for $200, hoping for 25% ROI ($250 net sale price)
- Coffee for $50, hoping for 100% ROI ($100 net sale price)
But due to the market conditions the actual sale prices were as follows:
- Playstation for $190
- Coffee for $160
The IRS would simply say:
- Cost of goods sold = $250
- Sales = $350
- Profit = $100
For tax purposes, they don’t care that you sold the Playstation ‘at a loss’. All that matters to them is that you spent X on inventory, and received Y in Sales.
This does touch on the concept of inventory valuation. You could state that if you used the cost method of inventory valuation and refused to sell the Playstation until the market came to you, you’d have a $200 inventory item, however, this is simply an accounting issue, and you can stand there until you are blue in the face with your $200 Playstations and never sell one, in many cases, the value of an item will drop over time, when the Playstation 5, 6 or 7 are released your Playstation 3 becomes less and less relevant.
You’ll never know the true value of an item until you own the last one – Hall 2016
There is truth to the concept that certain items do trade far beyond their MSRP when the supply is controlled. For example, when you have the very last pack of hair restoration cream that ‘works’ for some person in the middle of America, you could see the price jump from MSRP of $5.99 to $200. They simply ‘must’ have it. However, you have to pick and choose what inventory items will decay and depreciate.
How to use ROI
Firstly, you need to be aware of two negative internal factors: Ego and shitty education.
Ego arises when you hear people say things like: I’m not in the business of losing money, or I’m here for profit, let those other guys penny pinch. Those ‘other guys’ are the market, and you’ve already lost the money in many cases. An unrealized loss is still a loss unless things rebound.
That said, the key to making the decision on cutting a bad deal or not comes down to the basics of market forces: Supply and Demand.
If you are sitting on inventory with a price drop and supply is in abundance, you are unlikely to be able to out wait it before harm is done to your overall sales and profitability. If supply is constricted, and it is the right type of product (such as the hair repair cream) then waiting it out is actually a smart play. But that’s not an ego play, it’s a supply/demand play. Likewise, if you see Demand increasing in the future which would deplete the competition due to high sales, prices could rise again. When supply cannot keep up with demand, prices will (or at least should) balance the equation. You have to constantly ask, is it my ego?
Shitty education is the part where people hear of things like profit and ROI and trap themselves due to it. There are countless people out there who think it is bad business to sell at a loss. The reality is that the market is in control, and while you can sometimes predict future movement, waiting for it with nothing but your own ROI number will crush you. Nobody cares if you bought Ford stock at $50 per share or $5 per share when you want to sell it at 25% ROI, and unlike stock, Inventory is not a capital asset, so there is no itemized capital loss in most cases.
So how to actually use ROI in your business? You use it to explore whether you should attempt to open a position. If that position seems favorable at the time of opening, you have a punt on it. If the market changes based on Supply and Demand, you decide whether to cut loose, and move on not based on the original ROI or price paid. The decision instead should be what is the impact to growth on holding vs liquidating and moving on. Sometimes you were just wrong about the purchase, despite your best efforts.
This is why diversification is key to investing. You’ll often get very random results on a single product (or stock) based on the market. The product (or stock) might be exactly the same as when you bought it 3 months ago, but the price has halved. At some point in time, you have to take your ego, and the bits and pieces of education to the side and consider if the investment is good ‘today’.
When looking at an individual inventory item it is best to ignore purchase price entirely. That is the past. Instead, look at present price (are Playstations now on sale at $150? Were they always and you missed a coupon or stack?) and the future potential (without ego). Are they going to increase in value over time, or are they going to slowly depreciate? It’s also critical to understand the IRR concepts if you plan to wait for a price to increase. It might well be that due to IRR your 25% ROI target in 6 months is actually less profitable than selling today for 21.5%. It could even be that selling today at -5% ROI is worth more than a possible 25% if that sale never happens.
ROI is a critical metric, but it should be used when evaluating a purchase, and not when evaluating a sale. The purchase is always a gamble, so we use a metric to help us decide, but when you hold a product, be it a stock, or an inventory item in a lively and efficient market it is the laws of of Supply and Demand that should dictate when you sell, and for what price, which will tell you the ROI, rather than the ROI telling you what to set prices at.