What is ROI?
The Return on Investment (ROI) measures the profitability of an investment by comparing the net profits received at exit to the original cost of the investment.
How to Calculate ROI (Step-by-Step)
The ROI, an abbreviation for “return on investment”, is defined as the ratio between the net return and the cost of an investment.
- Net Return → Total Profits Received
- Cost of the Investment → Total Amount Spent
The return on investment (ROI) formula is straightforward, as the calculation simply involves dividing the net return on the investment by the investment’s corresponding cost.
In particular, the ROI is most commonly used for internal purposes within companies, such as for their decision-making processes regarding which projects to pursue and for decisions on how best to allocate their capital.
The higher the return on investment (ROI) on a project or investment, the greater the monetary benefits received — all else being equal.
However, what constitutes whether the ROI is adequate differs based on the target return specific to the investor and the length of the holding period, among other factors.
ROI Formula
The formula for calculating the return on investment (ROI) is as follows.
For purposes of comparability, the return on investment metric is typically expressed in percentage form, so the resulting value from the above formula must then be multiplied by 100.
The numerator in the formula, the return, represents the “net” return — meaning that the cost of the investment must be subtracted from either:
- Gross Returns (or)
- Total Exit Proceeds
Return on Investment Calculation Example (ROI)
For example, if the gross return on an investment is $100k while the associated cost was $80k, the net return is $20k.
- Gross Return = $100k
- Initial Cost = $80k
- Net Return = $20k
With that said, the return on investment can be calculated by dividing the $20k net return by the cost of $80k, which comes out to 25%.
- Return on Investment (ROI) = $20k ÷ $80k = 0.25, or 25%
What is a Good ROI?
The return on investment is a widespread metric due to its simplicity, since only two inputs are necessary:
- Net Return
- Cost of Investment
However, one drawback is that the “time value of money” is neglected, i.e. a dollar received today in worth more than a dollar received in the future.
If there are two investments with the same return, yet the second investment requires twice the amount of time until it is realized, the ROI metric on its own fails to capture this important distinction.
Therefore, when making comparisons among different investments, investors must ensure the time frame is the same (or nearby) or otherwise remain cognizant of the timing discrepancies between investments when putting together rankings.
One variation of the metric is called the annualized return on investment, which adjusts the metric for differences in timing.
Furthermore, a common mistake in calculating the metric is neglecting side expenses, which tends to be more applicable to projects in corporate finance.
The ROI calculation must factor in each and every profit and incurred cost associated with the project (e.g. unexpected maintenance fees) and investments (e.g. dividends, interest).
