What is Return on Investment (ROI)?
Return on investment (ROI) is a measure of the profitability of an investment. A high return on investment means that an investment generates favorable profit compared to its investment cost.
We commonly use ROI 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.
Return on investment – one tool
However, it should not be the only tool we use when making investment decisions. ROI, for example, 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 or produce goods. It also means to use resources to provide a future income or benefit.
We calculate ROI by dividing the return on an investment by its cost. We typically express ROI as either a percentage or a ratio.
Return on investment higher/lower than zero
An ROI higher than 0 means that profits are more than costs. An ROI below 0, on the other hand, means that costs are more than returns.
When comparing securities, it is useful to observe their ROI regularly.
Return on investment vs. profit
Return on investment is not the same as profit. We calculate ROI with the money somebody invests in a security and the return they gain on that money. We base this 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 it is possible to manipulate the calculations. In other words, we can express the calculations in different ways.
Calculating return on investment
For a single-period, you divide the return by the invested amount:
Return on investment (%) = (Net profit ÷ Investment) × 100
or:
Return on investment (%) = (Gains – Investment Costs) ÷ (Investment Costs)) x 100
Calculating the ROI of a new business:
Let’s assume that a business costs $500,000 to start up. We also expect it 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%.
Fair rate of return
If an investment has a ‘fair rate of return,’ it’s worth investing in, i.e., it’s worth the risk.
‘Fair rate of return’ also refers to the price limit that regulatory agencies or governments impose on utility companies.