Return on investment (ROI) is a fundamental concept used to evaluate the efficiency or profitability of any financial instrument. Whether investing in shares, bonds, or real estate, this simple measure can be calculated and expressed as a percentage to help you make better decisions. If you need help deciphering ROI measures and other financial data, working with an experienced financial advisor is a great option.
ROI is the ratio between net income and the cost of investment. Also known as return on costs (ROC), it is an attempt to measure the financial return of a particular investment over a set period. While ROI is not the only factor to consider when making an investment decision, it is perhaps one of the most important. If an investment has a high ROI, it is generally considered favorable.
How to Calculate ROI?
ROI is an important concept with a simple formula. It can be measured and expressed easily to enable fast and accurate comparisons. With this single formula, comparing multiple investments based on their returns is possible. In economics, ROI is a basic but effective way to measure profits compared to capital invested. It’s important to note, however, that ROI doesn’t consider risk, which can be a significant downfall.
In simple terms, ROI = (current value of investment – cost of investment) ÷ cost of investment
In even more simple terms, ROI = (profit – cost) ÷ cost
In the most simplest terms, ROI = net income ÷ investment
Let’s look at some basic examples to help you understand the ROI formula:
- If you make $10,000 and spend $8,000, your ROI would be (10,000 – 8,000) ÷ 8,000 = 0.25 or 25%.
- Generating $300,000 at a cost of $50,000 offers a much bigger ROI of (300,000 – 50,000) ÷ 50,000 = 5 or 500%.
- Making $33,333 while spending $50,000 offers an inverse ROI of (33,333 – 50,000) ÷ 50,000 = -0.33 or -33%.
Using ROI to Make Informed Investment Decisions
The ROI formula is typically used to assess the potential of profitability. Not only can you measure a particular investment, but you can also compare and contrast investments based on known criteria. You can measure the ROI of businesses, financial instruments, and even marketing campaigns. This versatile number is an essential indicator for anyone starting a business, and it’s also useful when diversifying, expanding, or opening up new product lines.
In the most basic terms, a positive ROI shows a profitable investment, while a negative ROI shows an unprofitable one. However, unrealistic percentages may also help to highlight underlying risks. Despite the simplicity of this measure, or perhaps because of it, wealth managers also use other ways to measure return on investment. Common examples include return on invested capital, the average rate of return, and return on equity. While ROI is front and center in most business decisions, these additional measures can shed new light on different aspects of profitability and risk.