What Is Return on Investment (ROI)?
Return on Investment (ROI) is a metric used to assess how profitable an investment is. Calculating the figure helps evaluate an investment’s performance and lets investors make an effective comparison between investment options to check which one is the most efficient.
The ROI allows individuals and businesses to observe the earnings from an investment against the expenditure on that investment. It is a financial ratio that lets businesses examine their position, depending on the returns their investments are likely to bear or have borne.
Table of Contents
- Return on investment (ROI) exhibits the performance of an investment to help individuals and businesses check the gains and losses made out of it. The higher the value, the better it is.
- ROI is calculated using a simple formula, i.e., net income divided by the original capital investment cost.
- The calculation method classifies ROIs into four categories – net income, capital gain, total return, and annualized return.
- It is easy to calculate and simple to read, understand, and interpret.
Return on Investment Explained
Return on investment signifies the profits made and the losses incurred on a particular investment. With the help of the obtained ROI, businesses and individuals get a chance to crosscheck their portfolios to understand which investments worked well for them and which have proven to be the wrong option.
ROIs intend to help investors learn how fruitful their investments have been. This allows them to assess their investment portfolio and be wise enough to make future investment decisions. In addition, they also let businesses validate their other expenses, which they make to achieve their business goals and objectives.
For example, if the profits garnered or losses incurred from investing in stocks is the ROI that helps individuals know where to invest the next time, the cost of advertising that helps generate leads and convert them into customers also acts as an investment. In the latter case, the number of leads generated and finally converted into consumers becomes the return on the investment made in advertising. In short, ROIs do not necessarily have a direct monetary value.
ROI can be calculated using different methods. Depending on the versions used for calculation, it is classified as – Net Income ROI, Capital Gain ROI, Total Return, and Annualized Return.
#1 – Net Income Method
ROI formula = (Net Income / Investment cost) * 100
#2 – Capital Gain Method
ROI Formula = (Current Share Price – Original Share Price) * 100 / Original Share Price
#3 – Total Return Method
ROI Formula = (Current Share Price + Total Dividends Received – Original Share Price) * 100 /Original Share Price
#4 – Annualized ROI Method
ROI Formula = [(Ending value / Beginning value) ^ (1 / no. of years)] – 1
The formula used in company analysis to calculate return on investment is:
Let us understand the return on investment meaning better using the following example:
Suppose an investor invested $1000 in the bakery in 2020 and sold his stock in 2021 at $1200. The above formula helps calculate the ROI in this case:
- ROI Bakery = (1200-1000) * 100 / 1000 = 20%
Next, he also invested $2000 in the shoe business in 2020 and sold his stock in 2021 at $2800. So, the same formula lets calculate the ROI here:
- ROI Shoes_Business = (2800-2000) * 100 / 2000 = 40%
This is how the ROI allows one to identify the best investment option available. The above example makes clear that investors can book more profit in the Shoe business as the ROI is higher than that of the bakery business.
Advantages & Disadvantages
While the highest or best return on investment indicates a better investment portfolio or efficient business, the poor ratio allows individuals and businesses to identify areas where they should not invest or spend. Though ROIs help to make better decisions, they are not a flawless approach. Here is a list of advantages and disadvantages that one must know of:
|Simple calculation||Manipulation risk exists|
|Easy to read and understand||Independent of the time factor|
|Helps compare the efficiency of firms and investments|
|A common method of calculating returns|
|Enables effective decision-making|
Return on Investment vs Return on Invested Capital vs Return on Equity
Returns can be calculated based on different parameters, which make them be called differently. Some such terms include return on investment (ROI), return on investment capital (ROIC), and return on equity (ROE). Though these terms signify the types of returns, the motive behind calculating them is different.
- ROI and ROIC are profitability ratios with different methods and factors for calculating returns. While the former measures the profits or losses incurred on a particular investment, the latter measures the portion of profits gathered by a company using invested capital from debt and equity providers. ROIC, in short, is a more specific measurement of returns.
- While ROI measures the return on the investment or other expenses a business or individual makes, ROE is the metric that helps firms understand how efficiently they use the money coming from their investors and shareholders to reap profits.
Frequently Asked Questions (FAQs)
If the return is 7 percent or more, it is considered a good and considerable ROI. Though the value may be higher in some years and poor in a few, having at least 7% ROI indicates consistency and stability in a business firm or individual investment portfolio.
While shareholders receive dividends as their ROI, debenture holders receive interest as the return on their investment. The latter’s return is received irrespective of whether the company reaps profits or not. With the help of debentures, investors receive a regular interest or coupon rate. In addition, the convertible debentures turn into equity shares at maturity. This makes the deal even more attractive to investors. Plus, debenture holders are preferred over common stockholders of the company when it comes to paying returns in the event of bankruptcy.
The shareholders’ ROIs come in the form of a dividend, a portion of the profits a company in which they invest makes. Another way in which they receive their returns is through capital growth. This means as the firm’s performance improves, the share value increases. As a result, the shares owned by those shareholders become more valuable with time.
This article has been a guide to what is Return on Investment. We explain its types, advantages, disadvantages, and formula with a calculation example, vs ROIC & ROE. You may learn more about Financial Analysis from the following articles –
- High-Low MethodHigh-Low MethodThe high-low method is used to separate fixed and variable cost elements from the historical cost mixture of fixed and variable costs. Fixed cost = highest activity cost – (variable cost per unit * highest activity units)
- Return on SalesReturn On SalesReturn on sales is a financial ratio depicting how efficiently a company can generate operating profit from its revenue. It measures the company's performance by analyzing what percentage of the income eventually results in profit for the company rather than its operating cost.
- TTM Revenue / LTM RevenuesTTM Revenue / LTM RevenuesLTM revenue, which stands for Last Twelve Months revenue (also known as TTM – trailing twelve months revenue), is the company's total revenue in the twelve months before the date of measurement; this helps in the company's valuation during a particular time.