Calculating Return on Investment (ROI)
Return on Investment Meaning
Return on Investment (ROI) is a tool used to measure the performance efficiency of an investment or compare the ability of some different investments. Return on Investment attempts to calculate the amount of return on a specific investment concerning the cost or expenses of the investment. The figures yielded on this measure are expressed in percentage or sometimes, in ratio.
In calculating Return on Investment, the general formula is:
ROI = (Current Value of Investment – Cost of Investment) / Cost Investment
In the given formula, “Current Value of Investment” refers to the proceeds accumulated from the sale of the investment of interest. Since Return on Investment is expressed in percentage, it can instantly provide figures as a reference to compare it from other investments, allowing investors to evaluate different investments and peg them against each other.
Sample ROI Formula Calculation
Say investor X purchases property 123, which costs $700,000. After two years, investor X sells property 123 for $1,400,000.
To calculate the investor X’s gain, let us use the basic formula given above.
ROI = (1,400,000 – 700,000) / 700,000 = 1 (in percentage = 100%)
Important note: There are other factors that might not be covered when accounting for the total cost of investment (i.e. transaction cost, taxes, time, and inflation).
ROI formula on fixed interest securities
Known for its simplicity and versatility, applying to almost all forms of business, Return on Investment has become handy and widespread use among investors. Return on Investment gauges the profitability of an investment. This includes investments in security classes.
If you want to calculate yields on bonds and other fixed interest securities, this formula is used:
Rate = Total Return____ X 100
ROI Formula Use
Calculations using the ROI formula are pretty simple and instantly aid investors in deciding whether to fight or flight from an investment opportunity. ROI yields significant indications of the health of an investment. ROI provides either a positive or negative rate which gives the investor an idea about the value of his investment.
Investors are favored with the following advantages using the ROI formulas to measure the performance of an investment:
- Simplicity and Ease in Calculations – many investors, fondly use the return on investment metric as it does not involve any complicated operations. The general equation or formula only requires two significant figures which are the cost and the total returns. Returns in the formula may be relative to different investors.
- Universally accepted– as the calculation doesn’t involve intricate steps, every investor can easily understand whatever results in the calculation yields. So using the metric during business negotiations is a guaranteed mutual understanding between investors.
Limitations of ROI
Despite being a handy tool for performance evaluation of investments, the ROI formula does not cover all the factors accountable to a particular investment. Here are some of the metric’s drawbacks:
- ROI formula is not time-bound – Getting favorable sky-high rates when calculating for returns using the ROI formula is not equal to finding the best investment available. For instance, an investor is faced with choosing a better investment between the two offered. To find out which investment is sounder and gives higher investment returns in no time, the investor uses the ROI formula to compare the two investments. Say the first investment will be completed in two years while the second option needs three years to complete while both investment options will produce the same target of returns. The ROI result would be even and does not give a clear picture of a more profitable investment concerning time since it only dealt with the cost and return it ought to yield. Considering the time factor, the first investment appears to be a better choice compared to the second one since it provides an equal amount of return in a shorter period.
- ROI formula can be manipulated – ROI calculation may yield varying results depending on which formula was used. For example, a business manager would persuade an investor to invest in the business. The business manager would use the general method in calculation return on investment. To impress the investor, the business manager tends to exclude other costs involved in the business operation (such as taxes, legal fees, maintenance expenditures, etc.) to yield high positive figures of returns.
The ROI concept may be applied to any form of investment provided that the formula is modified to include all factors pertinent to a particular investment to yield accurate figures of returns.