A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. ROI measures the amount of return on an investment relative to the investment’s cost. To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment, and the result is expressed as a percentage or a ratio.
The return on investment formula:
In the above formula, “Gain from Investment” refers to the proceeds obtained from the sale of the investment of interest. Because ROI is measured as a percentage, it can be easily compared with returns from other investments, allowing one to measure a variety of types of investments against one another.
BREAKING DOWN ‘Return On Investment – ROI’
Return on investment is a very popular metric because of its versatility and simplicity. Essentially, return on investment can be used as a rudimentary gauge of an investment’s profitability. ROI can be very easy to calculate and to interpret and can apply to a wide variety of kinds of investments. That is, if an investment does not have a positive ROI, or if an investor has other opportunities available with a higher ROI, then these ROI values can instruct him or her as to which investments are preferable to others.
For example, suppose Joe invested $1,000 in Slice Pizza Corp. in 2010 and sold his shares for a total of $1,200 a year later. To calculate the return on his investment, he would divide his profits ($1,200 – $1,000 = $200) by the investment cost ($1,000), for a ROI of $200/$1,000, or 20%.
With this information, he could compare the profitability of his investment in Slice Pizza with that of other investments. Suppose Joe also invested $2,000 in Big-Sale Stores Inc. in 2011 and sold his shares for a total of $2,800 in 2014. The ROI on Joe’s holdings in Big-Sale would be $800/$2,000, or 40%. Using ROI, Joe can easily compare the profitability of these two investments. Joe’s 40% ROI from his Big-Sale holdings is twice as large as his 20% ROI from his Slice holdings, so it would appear that his investment in Big-Sale was the wiser move.
Limitations of ROI
Yet, examples like Joe’s reveal one of several limitations of using ROI, particularly when comparing investments. While the ROI of Joe’s second investment was twice that of his first investment, the time between Joe’s purchase and sale was one year for his first investment and three years for his second. Joe’s ROI for his first investment was 20% in one year and his ROI for his second investment was 40% over three. If one considers that the duration of Joe’s second investment was three times as long as that of his first, it becomes apparent that Joe should have questioned his conclusion that his second investment was the more profitable one. When comparing these two investments on an annual basis, Joe needed to adjust the ROI of his multi-year investment accordingly. Since his total ROI was 40%, to obtain his average annual ROI he would need to divide his ROI by the duration of his investment. Since 40% divided by 3 is 13.33%, it appears that his previous conclusion was incorrect. While Joe’s second investment earned him more profit than did the first, his first investment was actually the more profitable choice since its annual ROI was higher.
Examples like Joe’s indicate how a cursory comparison of investments using ROI can lead one to make incorrect conclusions about their profitability. Given that ROI does not inherently account for the amount of time during which the investment in question is taking place, this metric can often be used in conjunction with Rate of Return, which necessarily pertains to a specified period of time, unlike ROI. One may also incorporate Net Present Value (NPV), which accounts for differences in the value of money over time due to inflation, for even more precise ROI calculations. The application of NPV when calculating rate of return is often called the Real Rate of Return.
Keep in mind that the means of calculating a return on investment and, therefore, its definition as well, can be modified to suit the situation. it all depends on what one includes as returns and costs. The definition of the term in the broadest sense simply attempts to measure the profitability of an investment and, as such, there is no one “right” calculation.
For example, a marketer may compare two different products by dividing the gross profit that each product has generated by its associated marketing expenses. A financial analyst, however, may compare the same two products using an entirely different ROI calculation, perhaps by dividing the net income of an investment by the total value of all resources that have been employed to make and sell the product. When using ROI to assess real estate investments, one might use the initial purchase price of a property as the “Cost of Investment” and the ultimate sale price as the “Gain from Investment,” though this fails to account for all of the intermediary costs, like renovations, property taxes and real estate agent fees.
This flexibility, then, reveals another limitation of using ROI, as ROI calculations can be easily manipulated to suit the user’s purposes, and the results can be expressed in many different ways. As such, when using this metric, the savvy investor would do well to make sure he or she understands which inputs are being used. A return on investment ratio alone can paint a picture that looks quite different from what one might call an “accurate” ROI calculation—one incorporating every relevant expense that has gone into the maintenance and development of an investment over the period of time in question—and investors should always be sure to consider the bigger picture