Return on Investment (ROI)
What is ROI?
Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency of multiple investments. ROI measures the net profit of an investment relative to its cost. It is a term you may quickly become familiar with when starting your business, or building an online store website.
How to calculate ROI
ROI is calculated by dividing the net profit of a particular investment by the cost. The result is expressed as a ratio or percentage.
This is the ROI formula:
ROI = (Current Value of Investment - Cost of Investment) / (Cost of Investment)
In this formula, the current value of investment refers to the benefit of the investment - i.e., the proceeds received from the sale.
Take a look at the ROI examples below to learn how to calculate ROI:
ROI Example 1
Sally purchases a property for $1,000,000. Three years later, she sells that property for $2,000,000.
Using the ROI formula, we can calculate her return on investment as follows:
ROI = (2,000,000 - 1,000,000) / (1,000,000) = 1 or 100%
Sally’s return on investment is 100%. That is, she made 100% of the money back that she invested.
ROI Example 2
John purchased $1,000 worth of stocks in a particular company. One year later, he sold his stock shares for a total of $1,500.
To calculate his return on investment, John divides his profits by the investment cost, using the ROI formula:
ROI = (1,500 - 1,000) / (1,000) = ½ or 50%
John’s return on investment is 50%.
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Benefits of ROI
There are many benefits of calculating ROI this way:
Easy to calculate: Only two numbers are needed to calculate ROI: the benefit and the cost. Using the return on investment formula is simple and fast.
Allows for quick comparison between investments: Calculating ROI helps you decide which investments yield the most gain. The greater the return on a particular investment, the more worthwhile it is to invest. This helps inform your investment decisions moving forward.
Universally understood: ROI is a metric used across industries and around the world. It’s a widely recognized concept that many people understand.
Limitations of ROI
Despite the benefits of ROI, the standard ROI formula isn’t perfect. This calculation is a rough estimate of return on investment, but there are some factors it doesn’t take into account:
Disregards the passage of time: This is the biggest downside to the standard ROI formula. It doesn’t factor in how many years it takes to yield a particular return on investment. A 100% return on investment after 1 year is far better than a 100% return on investment after 5 years, yet the formula doesn’t differentiate between the two.
May not account for all possible costs: True ROI accounts for all possible costs that went into an investment. This includes property taxes, sales fees, maintenance costs, legal costs and more. In order to accurately represent your ROI, you must include all these elements in your calculation.
Annualized ROI
Annualized ROI overcomes the main weakness of the traditional ROI formula: the failure to factor in time.
With the annualized ROI formula, you can calculate your return on investment in a way that takes into account the number of years that have passed.
Here is how to calculate annualized ROI:
Annualized ROI = {[(Current Value of Investment - Cost of Investment) / (Cost of Investment )] ^ (1/ Number of Years)} - 1
Where Number of Years = (End Date - Start Date) / 365
What is a good ROI?
There is no black-and-white answer for what constitutes a good return on investment. This depends on the risk tolerance of the investor, as well as the time required to generate a return. For some investors, a lower ROI is worthwhile if it corresponds to a low-risk investment. Likewise, investments that take a long time to generate a return typically need to yield a higher ROI in order to be worthwhile.