ROI & the Economic Rate of Return

Posted by Bonny Albo Mar 19, 2007

The Stanford Graduate School of Business free monthly Stanford Knowledgebase, reports on ROI and other financial accounting ratios that determine profitability, and how well the people who use these terms actually understand them.

The idea for the research came from a conversation between two of Standford's professors, Stefan Reichelstein and Mark Soliman. Reichelstein, a managerial accountant asked Soliman, a financial accountant, asked how financial ratios reflect real economic values.

“I said to him, ‘Take a firm in a competitive industry such as steel, construction, or agriculture and suppose the industry is in a steady state. Should we expect a typical firm’s return on investment to come down to the cost of capital because in a competitive industry the real economic rate of return must be equal to the cost of capital?’” Reichelstein recalled. “Mark's immediate answer was, ‘Of course, everybody knows that.’ And that’s how we got started, because (a) I certainly didn’t know it, and (b) I wasn’t so sure. When we began doing some calculations and model-building, it turned out there was a lot more to the story.”