Return on investment (ROI) is a measure of profitability of an investment. A high ROI means that an investment generates favorable profit compared to its investment cost.
It is commonly used to evaluate the efficiency of an investment, as it allows an investor to determine profits related to the amount of capital invested.
It is a cash flow metric that compares the amount and timing of investment gains with the amount and timing of costs.
However, it should not be the only tool used when making investment decisions, because an ROI does not represent the risk associated with a stock – it only looks at the comparison between returns and costs if the predicted results are achieved.
The word ‘investment’ refers to using resources (such as money or time) to make more money, produce goods, or provide a future income or benefit.
John is happy with his return on investment.
Calculating the ROI is done by dividing the return of an investment by its cost. ROI is typically expressed as either a percentage or a ratio.
An ROI higher than 0 means that profits are more than costs, whereas an ROI below 0 means that costs are more than returns. When comparing securities, it is useful to frequently observe their ROI.
Return on investment is not the same as profit. ROI is calculated with the money that is invested in a security and the return you gain on the money – which is based on the security’s net profit. However, profit measures a security’s performance. ROI is also not the same as the return on the owner’s equity.
A major downside of ROI is that its calculations can be manipulated – results can be expressed in different ways.
For a single-period you divide the return by the invested amount:
Return on investment (%) = (Net profit / Investment) × 100
Return on investment (%) = (Gains – Investment Costs)/ (Investment Costs)) x 100
Example of calculating the ROI of a new business:
Assume that a business is expected to cost $500,000 to start up and is projected to provide a total of $1,000,000 in profits over its first four years.
The ROI for this investment would be:
($1,000,000 – $500,000)/($500,000) x 100 = 100%
In the example above, the ROI would be 100%.
Video – Return on Investment