Return on Investment (“ROI”) is a ratio or percentage value that reflects the profitability or efficiency of a certain trade or investment.
ROI is a financial metric that is widely used to measure the probability of gaining a return from an investment.
It is a simple-to-use tool that can generate an absolute ratio (such as 0.50) or a value in percentage (such as 50%).
As such, ROI can also be used when comparing different types of investments or multiple trading operations.
Specifically, ROI evaluates the return on an investment in relation to its purchasing cost.
This means that the calculation of ROI is simply the return (net profit) divided by the total acquisition costs (net cost).
The result may then be multiplied by 100 to get the percentage value.
Naturally, a high ROI value indicates that the investment was profitable, while a negative ROI means the return was lower than the costs.
How to Calculate ROI
The calculation of ROI is based on the following equation:
ROI = (Current Value - Total Cost) / Total Cost
Alternatively, it may also be written as:
ROI = Net Profit / Net Cost
For example, imagine that Joe Mama bought a can of Noneya for $100.
Out of nowhere, cans of Nonya jump in price to $150.
Joe Mama sells his can. He would have an ROI of 0.50 or 50%.
Illustrating ROI with an Example
Let’s consider a more serious example.
Suppose you invest $1,000 into a promising start-up selling realistic fake poop. After a year, you decide to sell your stake and receive $1,200.
To calculate the ROI, you subtract your initial investment from the final amount, divide it by the initial investment, and then multiply by 100.
This will give you an ROI of 20%.
This percentage means that for every dollar you invested, you gained a profit of 20 cents.
It is a simplistic way of assessing the profitability of your investment.
Why is ROI important?
ROI is an incredibly versatile tool that finds application in personal finance, business profitability calculations, and comparative efficiency of different investments.
A higher ROI percentage indicates a more profitable investment, all else being equal.
In personal finance, an individual might use ROI to compare the effectiveness of different investment options such as real estate, stocks, or bonds.
In a business setting, companies often use ROI to compare the efficiency of different investments or to assess the profitability of different departments.
However, like any financial metric, ROI has its limitations. It should not be used in isolation when making investment decisions.
Limitations of ROI
While ROI is a useful measure, it doesn’t take into account the time value of money.
A high ROI does not necessarily mean a great investment. The investment’s duration is a crucial factor to consider – a 20% ROI over five years is less impressive than a 20% return achieved over one year.
Furthermore, ROI doesn’t reflect the risk associated with an investment.
Higher-risk investments often have higher potential ROIs to compensate for the increased risk of potential losses.
ROI also oversimplifies the investment returns, as it doesn’t consider ongoing expenses that might be associated with an investment, especially in cases of real estate and business investments.