What is Return on Investment (ROI)?
Return on investment (ROI) is a financial ratio used to calculate the benefit an investor will receive from their investment cost. It is most commonly measured as net income divided by the original capital cost of the investment. The higher the ratio, the greater the benefit earned. This guide will break down the ROI formula, outline several examples of how to calculate it, and provide an ROI formula investment calculator to download.
ROI Formula
There are several versions of the ROI formula. The two most commonly used are shown below:
ROI = Net Income / Cost of Investment
or
ROI = Investment Gain / Investment Base
The first version of the ROI formula (net income divided by the cost of an investment) is the most commonly used ratio.
The simplest way to think about the ROI formula is to take some type of “benefit” and divide it by the “cost”. When someone says something has a good or bad ROI, it’s important to ask them to clarify exactly how they measure it.
Example of the ROI Formula Calculation
An investor purchases property A, which is valued at $500,000. Two years later, the investor sells the property for $1,000,000.
We use the investment gain formula in this case.
ROI = (1,000,000 – 500,000) / (500,000) = 1 or 100%
The Use of the ROI Formula Calculation
ROI calculations are simple and help an investor decide whether to take or skip an investment opportunity. The calculation can also be an indication of how an investment has performed to date. When an investment shows a positive or negative ROI, it can be an important indication to the investor about the value of their investment.
Using an ROI formula, an investor can separate low-performing investments from high-performing investments. With this approach, investors and portfolio managers can attempt to optimize their investments.
Benefits of the ROI Formula
There are many benefits to using the return on investment ratio that every analyst should be aware of.
#1 Simple and Easy to Calculate
The return on investment metric is frequently used because it’s so easy to calculate. Only two figures are required – the benefit and the cost. Because a “return” can mean different things to different people, the ROI formula is easy to use, as there is not a strict definition of “return”.
#2 Universally Understood
Return on investment is a universally understood concept so it’s almost guaranteed that if you use the metric in conversation, then people will know what you’re talking about.
Limitations of the ROI Formula
While the ratio is often very useful, there are also some limitations to the ROI formula that are important to know. Below are two key points that are worthy of note.
#1 The ROI Formula Disregards the Factor of Time
A higher ROI number does not always mean a better investment option. For example, two investments have the same ROI of 50%. However, the first investment is completed in three years, while the second investment needs five years to produce the same yield. The same ROI for both investments blurred the bigger picture, but when the factor of time was added, the investor easily sees the better option.
The investor needs to compare two instruments under the same period and under the same circumstances.
#2 The ROI Formula is Susceptible to Manipulation
An ROI calculation will differ between two people depending on what ROI formula is used in the calculation. A marketing manager can use the property calculation explained in the example section without accounting for additional costs such as maintenance costs, property taxes, sales fees, stamp duties, and legal costs.
An investor needs to look at the true ROI, which accounts for all possible costs incurred when each investment increases in value.
Annualized ROI Formula
As mentioned above, one of the drawbacks of the traditional return on investment metric is that it doesn’t consider periods. For example, a return of 25% over 5 years is expressed the same as a return of 25% over 5 days. But obviously, a return of 25% in 5 days is much better than 5 years!
To overcome this issue we can calculate an annualized ROI formula.
ROI Formula = [(Ending Value / Beginning Value) ^ (1 / # of Years)] – 1
Where:
# of years = (Ending date – Starting Date) / 365
For example, an investor buys a stock on January 1st, 2017 for $12.50 and sells it on August 24, 2017, for $15.20. What is the regular and annualized return on investment?
Regular = ($15.20 – $12.50) / $12.50 = 21.6%
Annualized = [($15.20 / $12.50) ^ (1 / ((Aug 24 – Jan 1)/365) )] -1 = 35.5%