What is Return on Investment (ROI) and How it Works

Return On Investment

Return on investment (ROI) is an evaluation of the profitability of an investment. Let’s take a look at how to calculate ROI and its uses.

What Is ROI?

An ROI is a way of determining how much profit or loss you have made from investing or starting a business. An ROI is a basic ratio that divides an investment’s net profit (or loss) by its cost. Using ROI, an investor can evaluate the effectiveness of a particular investment or the profitability of multiple investments. It is similar to the return on assets (ROA) and the return on equity (ROE).

How to Calculate ROI

ROI formula:

ROI = (Net Profit / Cost of Investment) x 100

ROI = (Present Value – Cost of Investment / Cost of Investment) x 100

The proceeds from the sale of an interest-bearing investment are referred to as the “Present Value.” Since ROI can be calculated as a percentage, it can easily be compared to returns on other investments, allowing for the comparison of many different kinds of investments.

For example, if you invested $6,000 in XY company, you sold your share for $6,500 this week, and the duration of the investment is one year. Here is how you calculate your ROI for this investment:

ROI = ( $6,500 – $6,000 ) / $6,000

Your return on investment in XY company would be 8.33%. A more realistic calculation would include the costs associated with buying and selling shares, but this basic example ignores capital gains taxes.

How to Use ROI ?

There are diverse ways to calculate the ROI and a lot of benefits too. If you are a regular investor, you can use the ROI to scrutinize your portfolio. As well as ROI can be used to calculate any form of expense. 

Using ROI, business owners can calculate their return on investment in an advertisement, as an example. If a business owner spends $50,000 on advertising and it generates $870,000 in sales over the course of a year, the ROI is 1,640 percent. In order to make the right choice, a real estate owner mulling new appliances might examine the ROI of two different renovation options, considering cost and rent increases.

Just remember, ROI is calculated only as good as the number you feed, and it cannot eliminate the risk factor or vagueness. The ROI method can still be used to decide on future investments, but you must still consider the possibility that the projected net profit will be too optimistic or too pessimistic. Based on historical performance, there is no assurance of future success.

What is a Good ROI?

According to popular wisdom, a yearly ROI of approximately 7% or higher is considered a good ROI for an investment in stocks. According to the S&P 500, this is also the average return after accounting for inflation. Depending on the year, the return may be higher or lower. On average, your return will be around this amount. 

When deciding to invest, consider why, because the S&P 500 may not be appropriate for the level of risk you are willing to accept. Queries you need to ask yourself: 

Is the risk I’m willing to take worth it?

If I didn’t make this investment, what else could I do with the money?

Is there a risk of losing my investment?

Benefits of ROI

  • In general, calculating ROI is easy because you only need a few figures to complete the calculation, which is available in the financial statement or balance sheet.
  • Analyzing the comparative capability is easy and it is widely used because comparisons can be made for investment returns between organizations. 
  • An ROI calculation is based on the net profit from an investment in a particular business unit. It can provide a better measure of profitability by company/team.

Limitations of ROI

In ROI, there are some limitations or downsides. First of all, the return on investment is not time-dependent. If one of your investments had a 25% return over five years and another one had a return of investment of 20% over two years. With the basic ROI, you could not decide which investment was best because the ROI didn’t take into account compounding returns over time.

Through basic ROI, you cannot solve the above return, but the Annualized ROI can help because it avoids this limitation. For calculating annualized ROI, you need a little bit of algebra.

Annualized ROI = {[1 + (Net Profit / Cost of Investment)] (1/n) – 1} x 100

Formula represents the number of years the investment has been held.

Suppose you bought a portfolio of securities for $25,000; after five years, your portfolio was worth $39,000. Your annualized ROI would be 9.3%.

Annualized ROI = {[1 + (14,000 / 25,000)] (1/5) – 1} x 100 = 9.301%

The accurate calculation of the ROI depends on the total cost, not only the initial cost of investment. The calculations include transaction costs, taxes, maintenance costs, and other ancillary expenditures.

Finally, the ROI is calculated depending on evaluated future values, but that does not include any kind of risk assessment for the investors.