Return on Investment (“ROI”) is a ratio or percentage value that reflects the profitability or efficiency of a particular transaction or investment.
ROI is a financial metric widely used to measure the probability of receiving a return from an investment.
It is a simple and easy-to-use tool that can generate absolute ratios (e.g. 0.50) or percentage values (e.g. 50%).
Therefore, ROI can also be used to compare different types of investments or multiple trading operations.
Specifically, ROI evaluates the return on investment relative to its purchase cost.
This means that the ROI calculation is the return (net profit) divided by the total acquisition cost (net cost).
The result can be multiplied by 100 to get a percentage value.
Of course, a high ROI value indicates that the investment is profitable, while a negative ROI means that the return is less than the cost.
How to calculate ROI
ROI calculation is based on the following equation:
ROI = (Current Value - Total Cost) / Total Cost
can also be written as:
ROI = Net Profit / Net Cost
For example, let’s say Joe Mama buys a jar of Noneya for $100.
The price of a can of Nonya suddenly increased to $150.
Mama Joe sold his cans. His return on investment is 0.50 or 50%.
Illustrate ROI with examples
Let’s consider a more serious example.
Suppose you invest $1,000 in a promising startup selling realistic fake poop. One year later, you decide to sell your shares and receive $1,200.
To calculate ROI, you subtract the initial investment from the final amount, divide by the initial investment, and multiply by 100.
This will give you a 20%ROI.
This percentage means that for every dollar you invest, you make 20 cents in profit.
Here’s a simple way to evaluate the profitability of your investments.
Why is ROI important?
ROI is an extremely versatile tool that can be used for personal finance, business profitability calculations, and comparing the efficiency of different investments.
Other conditions being equal, a higher return on investment indicates a higher investment profit.
In personal finance, individuals may use ROI to compare the effectiveness of different investment options, such as real estate, stocks, or bonds.
In a business environment, companies often use ROI to compare the efficiency of different investments or to evaluate the profitability of different departments.
However, like any financial metric, ROI has its limitations. It should not be used alone when making investment decisions.
Limitations of ROI
While ROI is a useful metric, it does not take into account the time value of money.
High ROI does not necessarily mean a huge investment. Investment horizon is a key factor to consider – a 20% return on investment over five years is not as impressive as a 20% return over one year.
Additionally, investment rate of return does not reflect the risks associated with an investment.
Higher risk investments typically have a higher potential return on investment to compensate for the increased risk of potential loss.
ROI also oversimplifies the investment return because it does not take into account the on-going expenses that may be associated with the investment, especially in the case of real estate and business investing.
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