Return on investment, often referred to as “ROI,” is a metric that calculates what an investor stands to gain taking the cost of their investment into consideration. It gauges performance, the efficiency of an investment and the profitability of an investment. It can be used to compare one investment to another so you can determine the better place for your money.
What Is Return on Investment?
ROI is calculated as the benefit of a particular investment divided by its cost, according to the Corporate Finance Institute.
The result of calculating the ROI should tell you whether you want to seize the opportunity and buy in or take a pass on a low-performing alternative. ROI might be positive, or it could be negative. It’s a popular and often used tool because it’s both simple and accurate.
The ROI equation can be applied to a broad spectrum of types of investments from real estate to equity securities or even to buying an automobile. The higher the ratio, the more money or benefit you’re likely to realize.
Methods of Calculating ROI
The most common ROI calculation is simply net income divided by the initial cost of an investment, but there are variations.
ROI can also be calculated as your investment gain divided by your investment base, but this equation tells you your net profit in the past tense, not looking forward. You might make an investment of $10,000 and cash out later for $20,000. Your ROI would be $20,000 less $10,000 ($10,000) divided by $10,000: the gain of the investment less the cost of the investment divided by the cost of the investment. It works out to one in this example, or 100 percent, a good ROI indeed.
You can use the same equation looking forward if your investment is a sure thing, such as a product with guaranteed cash flow. This approach can be used if you’re contemplating different investments but you’re in a financial position where you can only commit to one. Say that Product A, the first investment, guarantees you $500 in cash flow, while Product B guarantees $600. You could buy into either for an investment cost of $200.
Your ROI for Product A would be $500 minus $200 divided by $200: 1.5 or 150 percent. It would be $600 minus $200 divided by $200 for Product B: 2 or 200 percent. Therefore, Product B produces a more positive return and is probably your best bet.
Some investors use the result of the formula in decimal form while others multiply the decimal by 100 to achieve a percentage, according to the University of Georgia. In either case, an investment with negative ROI is one you might want to stay away from.
Frequently Asked Questions
What Is a Good ROI?
The best ROI is obviously the higher ROI when you’re comparing two investments, but this depends on all entered data being equal. You should account for all potential maintenance costs in your equation, adding that number to your “buy in” beginning figure.
Annuity.org warns that your beginning figure should include all possible start-up costs. This might mean property taxes in the case of a real estate investment. It would include transaction costs if you were buying stocks, according to CFI. It can be tricky to compare different types of investments with different maintenance costs.
What’s the Difference Between ROI and IRR?
IRR stands for “internal rate of return.” It measures the rate at which an investment breaks even, according to Harvard Business Review. Internal rate of return is one of the ROI formulas commonly used, often by financial analysts.
How Does ROI Relate to the Time Frame of an Investment?
Basic ROI equations don’t factor in the impact of time, and this can be a shortcoming. Two investments might have identical ROIs but pay out in different periods of time. One might pay out in three years while the other won’t pay out for five years. The first would therefore be the better investment since you’d get your net profit two years sooner.
The traditional ROI formula doesn’t take time frames into consideration, but you can use a different ROI formula to get an annualized return. You would add in the factor of days held divided by 365 days in a year. CFI gives this example of a comparison of a traditional ROI formula versus an annualized formula with a stock purchased for $12.50 on Jan. 1 and sold on Aug. 24 for $15.20:
- Regular ROI = ($15.20 – $12.50) / $12.50 = 21.6 percent
- Annualized ROI = [($15.20 / $12.50) ^ (1 / ((Aug 24 – Jan 1)/365) )] -1 = 35.5 percent
References
Writer Bio
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.