In the paragraphs below, we are explaining how to calculate Return on Investment or ROI. But if you are new to the world of finance, you might not know what ROI is or might have only a vague notion of this concept. Before we show how to calculate ROI, a few words on the concept itself is in order.
What Is Return on Investment (ROI)?
Return on Investment is a performance measure. It is used in businesses to estimate the profitability or efficiency of an investment. ROI is also used to compare the efficiency of several investments. What Return on Investment does is it measures return on particular investment, compared to its cost.
Simply put, to calculate ROI, you need to divide the return of your investment (your profit) by its cost or outlay. The result is expressed either as percentage or a ratio. But note that ROI does not take into account the passage of time. Hence, it can miss opportunity costs of investing in some other businesses.
Suppose your investment has a profit of $100. If its cost is $100, its ROI will be 1, or 100%.
How to Calculate Return on Investment?
There is a formula to calculate your ROI. To calculate your Return on Investment, you need to subtract the cost of your investment from the current value of your investment. Then, you need to divide the received amount by the cost of your investment.
In this formula, Current Value of Investment is the proceeds received from the sale of the investment of interest. Note that ROI is measured as a percentage. Therefore, Return on Investment can be compared with returns from other investments, which enables you to measure your different investments against one another.
Why Is ROI Popular?
People prefer to use this metric because it is simple and applicable to various spheres of your business. It can help you precisely estimate the profitability of your investments. Whichever investment you make, use the Return on Investment formula to see whether it brings you profits. For example, you can count the ROI on a stock or asset investment, the ROI you expect on growing your business, or the ROI received in a real estate deal.
The ROI formula itself is so simple that even if you are not good at math, you will be able to interpret it. Simply put, if your investment’s ROI is positive, it means your business is profitable and can be moved forward. If you are choosing between several investment options, calculating ROI will come in handy as well. If you see that you have options with higher ROIs, you can easily choose the best option on offer, weeding out those that are less profitable. If you discover that return on your investment is negative, you will understand that your business is in trouble.
Limitations of ROI
As mentioned, ROI does not take into account the progress of time. When you compare your investments, you will keenly feel these limitations. Suppose you have made two different investments. When you compare them by using the ROI formula, you discover that, say, your first investment was thrice larger than your second investment. Yet you also discover that the time between your purchase and sale was half a year for your first investment but a year and a half for your second one. The ROI formula did not take these significant differences into consideration and disregarded the time value of money. If this is the case, you would need to adjust your year-and-a half investment, accounting for time differences between the two investments.
To refine your calculations and your business management, you are advised to use ROI together with the rate of return (RoR), which, unlike ROI, does consider your investment’s time frame.
Or you can use net present value (NPV). NPV accounts for differences in the value of money over time, due to inflation. Analysts often call the application of NPV when calculating the ROR the real rate of return. Alternatively, you can use such metrics as the internal rate of return (IRR).
What Is a Profitable ROI?
This question does not have a definite answer, because investors have to consider their risk tolerance and the time during which their investment starts generating a return to understand what ROI is good for them. If you hate taking risks, you might be ready to receive lower ROIs, provided you take lesser risks. If your investments take more time to begin earning you profits, they need to generate a higher ROI.
On average, companies listed on such large indices as the S&P 500 have the annual ROI of 10%. But ROIs differ from industry to industry. Tech companies may generate larger ROIs than energy ones, yet ROIs within one industry may also change over time, because of competition, technological innovations, and people’s preferences.