What is Return on Investment (ROI)? A Beginner’s Guide

Return on investment (ROI) is a performance measure used to evaluate the efficiency or profitability of an investment or compare the efficiency of a number of different investments. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost. The result is expressed as a percentage or a ratio, and is a popular metric because of its versatility and simplicity.

ROI is a critical metric that delivers valuable information to investors and other interested parties. By quantifying the gains or losses generated relative to the initial cost of an investment, ROI helps provide a clear snapshot of an investment's performance. Understanding ROI is essential for making informed financial decisions, guiding resource allocation, and optimizing strategies to either start or continue building profits.

Calculating ROI

The return on investment (ROI) formula is not extremely complicated and fairly intuitive, but it's worth spelling out for full transparency to avoid any potential confusion. The basic ROI calculation is as follows:

ROI = Current Value of Investment - Cost of Investment / Cost of Investment

“Current Value of Investment” refers to the proceeds obtained from the sale of the investment of interest. To calculate ROI, you need to know the starting investment and the net profit or loss from the investment. The result of the equation is simple to figure out and, since ROI is measured as a percentage of net income, it's easy to compare returns from one investment to another.

Initial Investment and Cost

The initial investment is the amount of money you put into an investment, and is an essential part of not only determining your ROI but maximizing it. This number could include purchase price, construction costs, or any other upfront expenses necessary to launch an investment opportunity. Properly accounting for this amount is imperative to form a baseline for precisely measuring investment returns.

The cost of an investment includes not only the initial capital that is used to start but also any additional costs, such as maintenance costs, transaction costs, fees, taxes, and more. Accurate ROI calculations need a full picture and depend on factoring in all costs, not merely the initial cost of the investment itself.

Why Is ROI a Useful Measurement?

Return on investment is a popular metric because of its versatility and simplicity.

ROI's straightforward utility is that it can be used as a rudimentary gauge of an investment’s profitability. If an investment’s ROI is net positive, it is probably worthwhile. If other opportunities with higher ROIs are available, these signals can help investors eliminate or select the best options.

The benefits of return on investment calculations don't end there, however. In addition to assessing the viability of an individual investment, it also allows for comparison between multiple different ones. This assists businesses and investors in their decision-making for choosing which investments to pursue with greater confidence.

One step further than that, ROI calculation helps to guide investors with their resource allocation when managing their investments. If you see that some asset classes are delivering notably stronger ROIs than others, it would make sense to prioritize those ones and devote more resources to the seemingly more lucrative opportunities.

Evaluating ROI Performance

Necessary in evaluating ROI performance in a way that delivers relevant and usable data involves several key factors. A large percentage or an attention-grabbing statement about an investment's ROI seems great in a vacuum, but context is often required by smart decision-makers to properly draw conclusions about the true value of the return on investment.

First, it helps to define your objectives that you desire your return on investment to accomplish. This could include revenue growth, cost reduction, or improved efficiency. You would then want to identify metrics that will accurately measure those objectives, metrics such as profit margins, customer acquisition costs, or simply overall revenue generated.

In general, a good ROI is one that is higher than the average annual return of the market or industry. For example, the average ROI for the S&P 500 historically has been about 10% per year. Within that, though, there can be considerable variation depending on the industry and the timeframe in which you are measuring.

Limitations of ROI

As useful as measuring return on investment can be, it is not without its limitations. ROI typically measures short-term goals, which may overlook long-term benefits and costs. This more or less only requires additional consideration toward the long game and a reluctance to accept immediate data as the end-all-be-all.

Tangential to that drawback is that ROI can be limited when comparing investments with different time frames. If one investment is structured to be realized relatively quickly, and the other time horizon is drawn out, the ROI figures don't consider the time value of money (i.e. the impact of inflation) and thus makes it difficult to properly compare the two returns.

Not every utilization of ROI is limited to investments, and not everything can be reported in numbers, of course. For employers and business management, return on investment fails to capture qualitative benefits such as customer satisfaction, brand loyalty, or employee morale. Despite not being tangibly measurable, these factors are essential pillars of success and ignoring them can lead to blind spots in management's perception of business performance.

ROI in Different Contexts

As we just touched on, ROI is used outside of only the investing realm. The need to measure "return on investment" is universal and at times not even literal. Return on investment of the time you dedicate to an activity is a legitimate concept that people wish to maximize, but for our purposes here we will continue exploring the more practical uses.

We've established that ROI can be used in personal finance to evaluate the performance of investments, such as stocks, bonds, and real estate. This is possibly its most common application and one that produces simple, effective results.

However, the ROI metric can also be used in business to evaluate the performance of various initiatives, such as new projects or acquisitions. Return on investment can additionally be needed in more macro contexts, such as evaluating the performance of a portfolio or comparing the performance of different investment managers.

Annualized ROI

Annualized ROI is a slight variation on what we've been discussing thus far, as it's a way to finely calculate ROI over a specific time period, usually a year. Annualized ROI takes into account the time value of money and provides a more accurate picture of an investment’s performance. This allows investors to standardize their return on investment figures and more easily compare the performance of two investments made with different time frames by converting returns into a consistent annual rate.

Calculating annualized ROI requires knowledge of the starting investment, the net profit or loss, and the time period. To see it in practice, consider the following example:

If you invested $1,000 and it grew to a present value of $1,500 over 3 years, the annualized ROI of this investment would be the quotient of the ending value ($1,500) divided by the beginning value ($1,000) raised to 1/n, "n" in this case being 3. You would then take the resulting number, subtract 1, and you are left with the decimal that you can convert to a percentage which would represent your annualized ROI. In the example given, the annualized return on investment is approximately 14.47% per year.

Using Leverage to Increase ROI

A more advanced undertaking, many experienced investors use leverage to increase ROI by accessing borrowed money to invest more upfront. Through leverage, you can control a larger amount of capital than you could with your funds alone, giving you enhanced opportunities for greater profitability ratios, provided your investments perform well.

However, leverage can also increase the risk of an investment, as the investor is responsible for paying back the loan. This means that if the investment decreases in value, your losses can exceed your initial investment but you're still on the hook for the money you owe as well as the interest. Proceed with caution and ensure that covering potential losses doesn't ruin you financially.

Greater potential returns, greater potential risks. Consider all the possibilities involved with using leverage before investing.

Best Practices for ROI Calculation

In order to produce the most accurate ROI figures, you must consider more than simply "how does the money you have now compare with what you had at the start of the investment?"

Factoring in all costs, not merely the initial cost of the investment itself, is imperative for painting a full picture of what went into the investment and therefore how much you gained or lost from it. Ideally, ROI calculations should be based on net profits, not gross profits. The final return on investment matters more than only how greatly the investment increased and then that's it.

Additionally, the calculations should take into account the time value of money and the risk of the investment. These account for external factors that might not be immediately thought of when calculating ROI but are nonetheless important for useful conclusions.

Conclusion

To sum up, return on investment is a useful metric for evaluating the performance of investments and making informed investment decisions. ROI is widely used in finance and business and is a popular metric among investors and financial analysts. However, ROI has its limitations, and it should be used in conjunction with other metrics to get a complete picture of an investment’s performance.