I recently had the “pleasure” of working with a marketing consultant who tried to improve performance for a mutual client by focusing intensely on achieving a high ROI across every one of their marketing channels. This type of thinking is very common in the ecommerce and online advertising world… and it’s VERY wrong. Most digital marketers don’t have a strong finance background or understand what actually drives profit. Nearly every digital marketer that I know misuses the term ROI… and some of them even have MBAs! Focusing on ROI kills profitability. We really need a revolution in thinking on this. Here’s why…
What Digital Marketers Call ROI Isn’t Actually ROI
ROI is an acronym from finance. It means return on investment. The formula for ROI is pretty simple. It actually is the return on top of the investment: the ratio of returns to the original investment that’s generating those returns. And it’s only valid when we’re speaking of assets. It is NOT proper to speak of ROI when we’re talking about income and expenses.
\[ ROI = \frac {Return} {Investment}\]As an example, if we spend $100 on a stock, it pays us $5 in dividends, that’s an ROI of 5/100, or 5%. Note that we still own that stock. If we sell it for $100 to someone else, that isn’t a return in addition to the original investment. It’s simply exchanging one asset (a stock) for another (cash). So if you invest $100 in stocks, get $5 in dividends, and then sell the stock and get your original $100 back…pay very close attention…your ROI is only 5%, not 105%. The cash you get back in this case is not a return on investment. It is a return of the investment, in a different form. ROI has no time period associated with it. But by convention, to make comparison of various investments easier, we often state ROI in terms of what it would be on an annual basis. So we’d say that a stock with a dividend yield of 5% per year has a 5% per year ROI (and yes, I know I’m simplifying this and ignoring changes in the value of the underlying stock).
So to restate:
- ROI is only valid when measuring returns on assets
- ROI doesn’t have a predefined time period
- ROI is usually stated in terms of annual percentages, but not always
- ROI is the return in addition to the value of the initial investment
Most marketers I know get this wrong, and the consultant in question got this very wrong. He wanted to understand our ROI from AdWords. I asked him to define ROI, so I’d know what he thought it meant. His definition was to take the revenue in a month and divide it by the expense in a month. So, if the revenue was $100K and the expense was $20K, he called that a 500% ROI.
I hope it’s clear to you how wrong this is. He’s applying the term ROI to income statement ratios (never appropriate), expecting that it has a monthly timeframe (it doesn’t), and including the original outlay of funds in the equation (like calling our stock with a 5% dividend a 105% return). What he called “ROI” was not ROI at all. It was ROAS (Return on Ad Spend). And ROAS is a very bad measure of performance and incredibly misleading when trying to compare against actual ROIs from assets. See my blog post on Why Return on Ad Spend Bidding Kills Ecommerce Profit for more on that.