Purpose: To measure levels and rates of profitability.

How does a company decide whether it is successful or not? Probably the most common way is to look at the net profits of the business. Given that companies are collections of projects and markets, individual areas can be judged based on how successful they are at adding to the corporate net profit. Not all projects are of equal size, however, and one way to adjust for size is to divide the profit by sales revenue. The resulting ratio is Return on Sales (ROS), the percentage of sales revenue that gets “returned” to the company as net profits, after all the related costs of the activity are deducted.

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Net Profit measures the fundamental profitability of a business. It is the revenues of the activity less the costs of the activity. The main complication is in more complex businesses, when overhead needs to be allocated across divisions of the company (see Figure 12.1). Almost by definition, overheads are costs that cannot be directly tied to any specific product or division. A classic example is the cost of headquarters staff.

Net Profit: A measure that calculates net profit for a unit (such as a company or division) by subtracting all costs, including a fair share of total corporate overheads, from the gross revenues.

Net Profit ($) = Sales Revenue ($) − Total Costs ($)

Return on Sales (ROS): Net profit as a percentage of sales revenue.

Return on Sales ROS (%)=Net Profit ($)Sales Revenue ($)

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA): A popular measure of financial performance. It is used to assess the “operating” profit of the business. It provides a rough way of calculating how much cash the business is generating and is even sometimes called the “operating cash flow.” EBITDA can be calculated by adding back the costs of interest, depreciation, and amortization charges and any taxes incurred.

EBITDA ($) = Net Profit ($) + Interest Payments ($) + Taxes Incurred ($) + Depreciation and Amortization Charges ($)

EBITDA can be useful because it removes factors that change the view of performance, depending on the accounting and financing policies of the business. Supporters argue that it reduces management’s ability to change the profits they report by their choice of accounting rules and the way they generate financial backing for the company. This metric excludes from consideration expenses related to decisions such as how to finance the business (debt or equity) and over what period to depreciate fixed assets. EBITDA is typically closer to actual cash flow than is NOPAT (discussed later in the chapter).

Data Sources, Complications, and Cautions

Although it is theoretically possible to calculate profits for any subunit, such as a product or region, often the calculations are rendered suspect by the need to allocate overhead costs. Because overhead costs often don’t come in neat packages, their allocation among the divisions or product lines of the company can often be more art than science.

For Return on Sales, it is worth bearing in mind that a “healthy” figure depends on the industry and capital intensity (the assets per sales dollar). Return on Sales is similar to Margin (%) except that ROS accounts for overheads and other fixed costs that are often ignored when calculating Margin (%) or Contribution Margin (%). (Refer to Section 3.1.)

Related Metrics and Concepts

Net Operating Profit After Tax (NOPAT): A measure that deducts relevant income taxes but excludes some items that are deemed to be unrelated to the main (“operating”) business.

Purpose: To measure per-period rates of return on dollars invested in an economic entity.

Return on Investment (ROI) and related metrics—Return on Assets (ROA), Return on Net Assets (RONA), Return on Capital Employed (ROCE), and Return on Invested Capital (ROIC)—provide a snapshot of profitability adjusted for the size of the investment assets tied up in the enterprise. Marketing decisions have obvious potential connection to the numerator of ROI (profits), but these same decisions often influence asset usage and capital requirements (for example, receivables and inventories). Marketers should understand the position of their company and the returns expected. ROI is often compared to expected (or required) rates of return on dollars invested.

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For a single-period review, just divide the return (net profit) by the resources that were committed (investment):

Return on Investment (%)=Net Profit ($)Investment ($)

Data Sources, Complications, and Cautions

Averaging profits and investments over periods such as one year can disguise wide swings in profits and assets, especially inventories and receivables. This is especially true for seasonal businesses (such as some construction materials and toys). In such businesses, it is important to understand these seasonal variations to relate quarterly and annual figures to each other.

ROI is often used to represent returns over a specified period of time. Later in this chapter we introduce Marketing Return on Investment (MROI), which is typically assessed on a specific marketing campaign.

Related Metrics and Concepts

Return on Assets (ROA), Return on Net Assets (RONA), Return on Capital Employed (ROCE), and Return on Invested Capital (ROIC) are commonly used variants of ROI. They are also calculated using net profit as the numerator, but they have different denominators. The relatively subtle distinctions between these metrics are beyond the scope of this book. Some differences lie in whether payables are subtracted from working capital and how borrowed funds and stockholder equity are treated.

Whenever you use financial accounting data, it is worth remembering that the formal objective of external financial reporting is not to provide a dollar value for any entity,¹ but to give background information in a standardized format. Therefore, the asset figures recorded in the financial accounts may differ substantially from an economic view of assets that a marketer might take.

Purpose: To measure dollar profits while accounting for required returns on capital invested.

Economic Profit, sometimes called Residual Income or the proprietary Economic Value Added (EVA),² is different from Accounting Profit in that Economic Profit also considers the cost of invested capital: the opportunity cost (see Figure 12.2). Like the discount rate for NPV calculations, this charge should also account for the risk associated with the investment.

Marketers are increasingly being made aware of how some of their decisions influence the amount of capital invested or assets employed. First, sales growth almost always requires additional investment in fixed assets, receivables, or inventories. Economic Profit helps determine whether these investments are justified by the profit earned. Second, the marketing improvements in supply chain management and channel coordination often show up in reduced investments in inventories and receivables. In some cases, even if sales and profit fall, the investment reduction can be worthwhile. Economic profit is a metric that helps assess whether these trade-offs are being made correctly.

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Economic Profit/EVA can be calculated in three stages:

1. Determine NOPAT.

2. Calculate the cost of capital by multiplying capital employed by the weighted average cost of capital.³

3. Subtract the cost of capital from NOPAT.

Economic Profit ($) = Net Operating Profit After Tax (NOPAT) ($) – Cost of Capital ($)

Cost of Capital ($) = Capital Employed ($) * WACC (%)

Economic Profit: A measure of profit in dollar terms. If profits are less than the cost of capital, the firm has lost value. Where economic profit is positive, value has been generated.

Data Sources, Complications, and Cautions

Economic Profit can give a different ranking for companies than does Return on Investment. This is especially true for companies, such as Walmart and Microsoft, that have experienced (achieved) high rates of growth in sales. Judging the historic results of the giant U.S. retailer Walmart by many conventional metrics would disguise its success. Although the rates of return are generally good, they hardly imply the rise to dominance that the company has achieved. Economic Profit reflects both Walmart’s rapid sales growth and its adequate return on the capital invested. The Economic Profit metric shows the magnitude of profits after the cost of capital has been subtracted. It combines the idea of a return on investment with a sense of volume of profits. Simply put, Walmart achieved the trick of continuing to gain decent returns on a dramatically increasing pool of capital.

Purpose: To evaluate investments with financial consequences spanning multiple periods.

“Investment” is a word businesspeople like. It has all sorts of positive connotations of future success and wise stewardship. However, because not all investments can be pursued, those available must be ranked against each other. Also, some investments are not attractive even if we have enough cash to fund them. In a single period, the return on any investment is merely the net profits produced in the time considered divided by the capital invested. Evaluation of investments that produce returns over multiple periods requires a more complicated analysis—one that considers both the magnitude and timing of the returns.

Payback (#): The time (usually years) required to generate the (undiscounted) cash flow to recover the initial investment.

Net Present Value (NPV) ($): The present (discounted) value of future cash inflows minus the present value of the investment and any associated future cash outflows.

Internal Rate of Return (IRR) (%): The discount rate that results in a net present value of zero for a series of future cash flows after accounting for the initial investment.

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Data Sources, Complications, and Cautions

Payback and IRR calculations require estimates of cash flows. The cash flows are the monies received and paid out that are associated with the project per period, including the initial investment. Topics that are beyond the scope of this book include the time frame over which forecasts of cash flows are made and how to handle the “terminal value” (the value associated with the opportunity at the end of the last period).⁵ Net present value calculations require the same inputs as payback and IRR plus one other: the discount rate. Typically, the discount rate is decided at the corporate level. This rate has a dual purpose to compensate for the following:

• The time value of money

• The risk inherent in the activity

A general principle to employ is that the riskier the project, the greater the discount rate to use. Considerations for setting the discounts rates are beyond the scope of this book. We can simply observe that, ideally, separate discount rates would be assessed for each individual project because risk varies by activity. A government contract might be a fairly certain project, but an investment by the same company in buying a fashion retailer could carry a lot of risk. The same concern occurs when companies set a single hurdle rate for all projects assessed using IRR analysis.

Purpose: To measure the rate at which spending on marketing contributes to profits.

Marketers are under more and more pressure to “show a return” on their activities. However, it is often unclear exactly what this means. Certainly, marketing spending is often not treated as an “investment” in current accounting practice. There is usually no tangible asset—nor even a predictable (quantifiable) result to show for the spending—but marketers still want to emphasize that their activities contribute to financial health. Some might argue that marketing should be considered an expense, and the focus should be on whether it is a necessary expense. Marketers, however, typically believe that many of their activities generate lasting results and therefore should be considered investments in the future of the business.⁶

Marketing Return on Investment (MROI) or Return on Marketing Investment (ROMI): The incremental financial value attributable to marketing (net of marketing spending), divided by the marketing “invested” or risked.

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A necessary step in calculating MROI is the estimation of the incremental financial value attributable to marketing. This incremental value can be the total attributable to marketing or the marginal value attributable to a new marketing initiative. The following example and Figure 12.3 should help clarify the difference:

Y₀ = Baseline financial value (with $0 marketing spending)

Y₁ = Financial value at marketing spending level X₁

Y₂ = Financial value at marketing spending level X₂

In this case, the difference between X₁ and X₂ represents the cost of an incremental marketing budget item that is to be evaluated, such as an advertising campaign or a trade show.

Three important marketing calculations can be illustrated with Figure 12.3.

Financial Value Attributable to Marketing = Y₂ – Y₀: The increase in financial value attributable to the entire marketing budget (equal to financial value with marketing minus baseline financial value).

Marketing Return on Investment (MROI) = [(Y₂ – Y₀) – X₂]/X₂: The financial value created by all marketing activities divided by the cost of those activities.

Return on Incremental Marketing Investment (ROIMI) = [(Y₂ – Y₁) –(X₂– X₁)]/(X₂ – X₁): The incremental financial value due to the incremental marketing spending divided by the amount of incremental spending.

For some industries, revenue-based metrics might be useful but must be interpreted differently. (See the Return on Advertising Spend metric in Section 10.8.) MROI and ROIMI, as shown in the following examples, are generally more direct measure of marketing’s effect on firm profits.

Marketing Return on Investment (MROI) (%)=Incremental Financial Value Created byMarketing ($)−Cost of Marketing ($)Cost of Marketing ($)

Data Sources, Complications, and Cautions

The first piece of information needed for MROI is the cost of the marketing campaign, program, or budget. Although defining which costs belong in marketing can be problematic, a bigger challenge is estimating the incremental revenue, contribution, and net profits attributable to marketing. This is similar to the distinction between baseline and lift discussed in Section 9.1. Farris and his colleagues⁷ outline five ways that financial returns are often assessed; see Table 12.4.

We suggest that it is important to understand the approach being used and to ensure that it is appropriate for the situation.

A further complication of estimating MROI concerns how to deal with important interactions between different marketing programs and campaigns. The return on many marketing “investments” is likely to show up as an increase in the responses received for other types of marketing. For example, if direct mail solicitations show an increase in response because of television advertising, we could and should calculate that those positive outcomes had something to do with the TV campaign. As an interaction, however, the return on advertising would depend on what was being spent on other programs. The function is not a simple linear return to the campaign costs.

For budgeting, one key element to recognize is that maximizing the MROI would probably reduce spending and profits. Marketers typically encounter diminishing returns, with each incremental dollar yielding lower and lower incremental MROI, and so low levels of spending will tend to have very high return rates. Maximizing MROI might lead to reduced marketing and eliminating campaigns or activities that are, on balance, profitable, even if the return rates are not as high as the first campaigns chosen. This issue is similar to the distinction between ROI (%) and EVA ($) discussed in Sections 12.2 and 12.3. Additional marketing activities or campaigns that bring down average percentage returns but increase overall profits can be quite sensible. So, using MROI or any percentage measure of profit to determine overall budgets is questionable. Of course, merely eliminating programs with a negative MROI is almost always a good idea. Still, maximizing long-term profits is often not simply a matter of shifting funds from low-ROI activities to high-ROI activities because there may well be strategic considerations not fully captured in the ROI measures themselves. Examples are brand building and new customer acquisition versus the need for short-term sales, balancing push and pull efforts to support distribution channels, and targeting market segments that are of strategic importance.

The previous discussion intentionally does not deal with any carryover effect (that is, a marketing effect on sales and profits that extends into future periods). When marketing spending is expected to have effects beyond the current period, other techniques are needed, including Payback, Net Present Value, and Internal Rate of Return (discussed earlier in this chapter). Also, Customer Lifetime Value (see Section 5.3) provides a more disaggregated approach to evaluating marketing spending and is designed to acquire long-lived customer relationships.

All of the above discussion is based on referring to the “R” in MROI as “return of profit” resulting from marketing expenditures. The reality is that several firms today are now using return in various different dimensions other than just profit contributions. While this can be confusing, part of the reason for it might be that the immediate profits are less obvious, costs are unknown, or the associated incremental revenue is not easy to determine. Hence, many are referring to “return” per dollar spent as a way to judge achieving some interim stage in the purchase funnel, as described below.

Related Metrics and Concepts

Purpose: To measure marketing impact on the stock price.

As marketers advance in their careers, especially if they become chief marketing officers (CMOs), they are likely to want to understand as best as possible how marketing might affect the stock price. Here we give some key metrics frequently employed by colleagues in the finance disciplines.

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Data Sources, Complications, and Cautions

Market capitalization is the value of the owners’ equity at any given point, but throughout a period, a firm might issue, buy back, split, or merge shares. Don’t forget to adjust for such changes. Furthermore, firms may issue shares with different rights, and so these may also differ in value.

Many marketers find it difficult to accept the argument that financial markets are sufficiently efficient to incorporate all available information and give good predictions about the impact of marketing actions on future earnings. When markets are thought to be less efficient, any metric that uses them loses value.

How you choose what returns are “normal” directly affects estimates of “abnormal” returns. Furthermore, even if an estimate of abnormal return assessment is accurate, we may question whether any associated event was the cause of the estimated abnormal return.

The time window assessed for abnormal returns can make a big difference. A very short window may miss genuine changes if the market takes a longer time to respond. Longer windows typically also increase noise in the data as other events happen (for example, competitor actions, macroeconomic news), thereby also reducing confidence that any changes in returns are tied to the event being studied.

Purpose: To measure firm worth in terms of earnings and market price.

Earnings is a single-period accounting measure, whereas the market price, in an efficient market, reflects all future earnings expected to be gained by a firm. A high Price to Earnings (PE) Ratio thus may suggest that a larger stream of earnings is expected in the future.

Market to Book Ratio compares financial markets valuations (assumed to be forward looking) with financial accounting records (which are generally backward looking). Proponents thus suggest that this measure shows when value has been created but has yet to be recorded in the financial accounts. There are very significant caveats associated with Market to Book Ratio, so we caution against using it—at least to measure performance.

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Earnings per Share (EPS) Ratio: A measure calculated by dividing a company’s reported earnings by the number of shares outstanding. This data is contained in the financial accounts.

Earnings per Share (EPS) ($)=Earnings of Company ($)Number of Shares Outstanding ($)

Price to Earnings (PE) Ratio: The market price per share divided by the earnings per share.

Price to Earnings (PE) Ratio ($)=Price of Single Share ($)Earnings per Share ($)

Market to Book Ratio: A measure of the market value of the equity of a firm (taken from stock market reports) divided by the book value of the owners’ equity reported in the financial accounts. (This value of equity is the assets of the firm less its liabilities.) High values suggest that value has been created and noticed by the market but not yet recorded in the financial accounts.

Market to Book Ratio (I)=Market Value of Equity ($)Book Value of Equity ($)

Price to Book Ratio: A measure that can be thought of as the Market to Book Ratio at the individual share level.

Price to Book Ratio (I)=Market Value of a Single Share ($)Book Value of a Single Share ($)

Tobin’s q: A measure used by academics that is similar to Market to Book Ratio.

Tobin’s q (I)=Market Value of Assets ($)Replacement Cost of Assets ($)

The market value of assets is the value of the equity plus the value of preferred stock and debt. The replacement cost of assets is hard to estimate, so accounting-based measures use book values as approximations (typically “Total Assets” from the financial accounts).

Accounting Based Approximation of Tobin’s q (I)=Market Value of Equity ($)+Preferred Stock ($)+Debt ($)Total Assets ($)

Book value understates replacement value for marketing-intensive firms. This means Tobin’s q is typically higher for marketing-intensive firms than for comparably successful non-marketing-intensive firms. This makes accounting-based approximations of Tobin’s q problematic for measuring performance.⁹

Data Sources, Complications, and Cautions

Share price, in efficient markets, is often assumed to be an unbiased estimate of suitably discounted future cash flows, the value of which will accrue to the shareholders. Of course, how efficient financial markets actually are is a matter of ongoing debate.

Financial accounting numbers (such as earnings and book value) come from regular periodic reports, but the market value of equity can be a real-time value. Make sure to compare market and book values for the same time periods.

Accounting numbers are problematic for marketers, given that nearly all investments in marketing are expensed (that is, treated as costs). For example, brands are often omitted from financial accounting records when created by internal investments. If fewer assets are recorded, but all liabilities are recorded, then reported equity will be less at the same level of performance. We would expect Price to Earnings Ratio and Market to Book Ratio to be higher for firms that invest heavily in marketing.

Further Reading

Bendle, Neil Thomas, and Moeen Naseer Butt. (2018). “The Misuse of Accounting-Based Approximations of Tobin’s q in a World of Market-Based Assets,” Marketing Science, 37(3), 484–504.

Farris, Paul W., Dominique M. Hanssens, James D. Lenskold, and David J. Reibstein. (2015). “Marketing Return on Investment: Seeking Clarity for Concept and Measurement,” Applied Marketing Analytics, 1(3), 267–282.

Hawkins, D. I., Roger J. Best, and Charles M. Lillis. (1987). “The Nature and Measurement of Marketing Productivity in Consumer Durables Industries: A Firm Level Analysis,” Journal of the Academy of Marketing Science, 1(4), 1–8.