Return on Investment (ROI) Definition
Return on investment (ROI) is a financial ratio that indicates how well an investment performed (gained or lost money) in comparison to the amount invested. ROI is calculated using a simple formula i.e., net income divided by the original capital cost of investment. Higher the ROI of the business, the better the business is performing.
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For eg:
Source: Return on Investment (ROI) (wallstreetmojo.com)
Return on Investment Formula
ROI Formula = (Net Profit / Cost of Investment) * 100
This formula is flexible in calculation and used by the different investors to compare ROI on different potential investments and returns on stocks.
Examples
Let’s see some simple to advanced examples to understand the concept better.
Example #1
An investor buys $10,000 of stocks and sells the shares 1 year later with the amount of $12,000. The net profit from an investment is $2,000, and ROI is as follows:-
- Return on Investment
So from the above calculation of Return on Investment will be:
This is an actual profit, including taxes and fees.
“Gain from investment” refer to sales of investment interest. Return on investment is measured as a percentage; it can be easily compared with returns from other investments, allowing one to measure a variety of types of investment against one another.
Hence, return on investment is a difference of gain from investment and cost of investment upon the total cost of investment.
Example #2
An investor invested $15,000 and sell the same after a few years, and he sells the same at $20,000. Then, ROI will be as follows.
- Return On Investment
So from the above calculation of Return on Investment will be:
Example #3
Suppose an investor invests $1000 in the bakery in 2015 and sold his stock in 2016 at $1200. Then, the ROI Formula will be as follows:-
ROI Bakery = (1200-1000) * 100 / 1000 = 20%
He also invested $2000 in the shoe business in 2015 and sold his stock in 2016 at $2800. Then ROI Formula will be as follows:-
ROI Shoes_Business = (2800-2000) * 100 / 2000 = 40%
So, through ROI, one can calculate the best investment option available. We can see that investor book more profit in the business of Shoes as the return on investment is the shoe business is higher than the bakery business.
4 Methods to Calculate Return on Investment
There are a total of four methods to calculate return on investment calculation.
Now, let us the calculation of ROI formula with the below methods:-
#1 – Net Income Method
ROI formula = (Net Income / Investment value) * 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
Uses
- The return on investment formula is used in finance by corporations in any form of investment like assets, projects, etc.
- It measures the return on investment like return on assets, returns on capital, etc.
Benefits
- Simple and easy to understand- It is easy to calculate, and it can be calculated by two figures that are benefit and cost.
- Helpful in benchmarking and comparison purposes.
- Universally understood- This ratio is very popular and commonly used.
Limitations
- Susceptible to Manipulate- The calculation differs based on investors; some consider one aspect, and others ignore it so it can be manipulated easily.
- Disregards the factor of time- The investor needs to compare two instruments under the same time period and same circumstances. ROI is not dependent on time; hence we cannot see the impact of the time period through this.
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