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What Is Return on Investment (ROI)?
Expressed as a percentage, return on investment (ROI) is a financial ratio that measures the profit generated by an investment relative to its cost. Key factors influencing ROI include the initial investment amount, ongoing maintenance costs, and the cash flow generated by the investment.
To calculate ROI, the return of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.
Key Takeaways
- Return on Investment (ROI) is a popular profitability metric used to evaluate how well an investment has performed.
- ROI is expressed as a percentage and is calculated by dividing an investment’s net profit (or loss) by its initial cost or outlay.
- ROI can be used to make apples-to-apples comparisons and rank investments in different projects or assets.
- ROI does not account for the holding period or passage of time, and therefore, it can overlook the opportunity costs of investing elsewhere.
- Whether an asset delivers a good ROI should be compared to other available opportunities.
Investopedia / Lara Antal
How to Calculate Return on Investment (ROI)
The return on investment (ROI) formula is as follows:
ROI=Cost of InvestmentCurrent Value of Investment−Cost of Investment
The “Current Value of Investment” is the value of an investment at a given moment. For stocks or other similar investments, it is the current market value, plus any fees or other expenses incurred at the time of purchase.
For a project, it includes factors like the discounted cash flow over the investment’s lifetime and any maintenance costs incurred. “Cost of Investment” is how much an investment was purchased for, including fees and expenses. Project costs at the time the project was financed are included.
Because ROI is measured as a percentage, it can be easily compared with returns from other investments, allowing one to measure a variety of investment types against one another.
Why Is ROI a Useful Measurement?
ROI is a popular metric because of its versatility and simplicity. Essentially, ROI can be used as a rudimentary gauge of an investment’s profitability. This could be the ROI on a stock investment, the ROI a company expects on expanding a factory, or the ROI generated in a real estate transaction.
The calculation itself is not complicated, and it is relatively easy to interpret for its wide range of applications. If an investment’s ROI is net positive, it is probably worthwhile. But if other opportunities with higher ROIs are available, these signals can help investors eliminate or select the best options. Likewise, investors should avoid negative ROIs, which imply a net loss.
For example, suppose Jo invested $1,000 in Slice Pizza Corp. in 2017 and sold the shares for a total of $1,200 one year later. To calculate the return on this investment, divide the net profit ($1,200 – $1,000 = $200) by the investment cost ($1,000), for an ROI of $200 ÷ $1,000, or 20%.
With this information, one can compare the investment in Slice Pizza with that of other projects. Suppose Jo also invested $2,000 in Big-Sale Stores Inc. in 2014 and sold the shares for a total of $2,800 in 2017. The ROI on Jo’s holdings in Big-Sale would be $800 ÷ $2,000, or 40%. When comparing these investments, it’s also important to account for the number of years each investment was held.
What Are the Limitations of ROI?
Examples like Jo’s (above) reveal some limitations of using ROI, particularly when comparing investments. While the ROI of Jo’s second investment was twice that of the first investment, the time between Jo’s purchase and the sale was one year for the first investment but three years for the second.
Jo could adjust the ROI of the multi-year investment accordingly. Since the total ROI was 40%, to obtain the average annual ROI, Jo could divide 40% by 3 to yield 13.33% annualized. With this adjustment, it appears that while Jo’s second investment earned more profit, the first investment was actually the more efficient choice.
ROI can be used in conjunction with the rate of return (RoR), which takes into account a project’s time frame. One may also use net present value (NPV), which accounts for differences in the value of money over time due to inflation. The application of NPV when calculating the RoR is often called the real rate of return.
What Is a Good ROI?
Determining what constitutes a “good” ROI is crucial for investors seeking to maximize their returns while managing risk. While there’s no universal benchmark, several factors influence what’s considered satisfactory.
- Risk tolerance: Investors vary in their willingness to tolerate risk. Those who are more risk-averse may accept lower ROIs in exchange for greater stability and predictability in their investments. On the other hand, risk-tolerant investors may seek higher ROIs but are willing to accept greater uncertainty and volatility.
- Investment duration: The time horizon of an investment plays a significant role in determining what qualifies as a good ROI. Longer-term investments typically require higher ROIs to justify tying up capital for an extended period. Shorter-term investments may offer lower ROIs but provide liquidity and flexibility.
- Industry norms: Different industries have varying expectations for ROI based on factors such as market conditions, competitive landscape, and regulatory environment. For example, industries with high barriers to entry or significant capital requirements may require higher ROIs to attract investment.
- Personal goals: Ultimately, what qualifies as a “good” ROI depends on an investor’s specific financial objectives. Whether aiming for wealth accumulation, income generation, or capital preservation, investors should align their ROI expectations with their individual goals and circumstances.
What Are the Wider Applications of ROI?
Some investors and businesses have taken an interest in the development of new forms of ROIs, called social return on investment (SROI). SROI was initially developed in the late 1990s and takes into account broader impacts of projects using extra-financial value (i.e., social and environmental metrics not currently reflected in conventional financial accounts).
SROI helps understand the value proposition of specific environmental, social, and governance (ESG) criteria used in socially responsible investing (SRI) practices. For instance, a company may decide to recycle water in its factories and replace its lighting with all LED bulbs. These undertakings have an immediate cost that may negatively impact traditional ROI; however, the net benefit to society and the environment could lead to a positive SROI.
There are several other new variations of ROIs that have been developed for particular purposes. Social media statistics ROI pinpoints the effectiveness of social media campaigns, for example, how many clicks or likes are generated for a unit of effort. Similarly, marketing statistics ROI tries to identify the return attributable to advertising or marketing campaigns.
Tip
So-called learning ROI relates to the amount of information learned and retained as a return on education or skills training. As the world progresses and the economy changes, several other niche forms of ROI are sure to be developed in the future.
What Is ROI in Simple Terms?
Basically, return on investment (ROI) tells you how much money you’ve made (or lost) on an investment or project after accounting for its cost.
Is ROI Calculated Annually?
ROI can be calculated over any period, but it’s most commonly calculated on an annual basis. This allows for easier comparison between different investments and provides a standardized measure of performance. However, in some cases, ROI can also be calculated over shorter or longer periods depending on the specific context and needs of the analysis.
How Do You Calculate Return on Investment (ROI)?
Return on investment (ROI) is calculated by dividing the profit earned on an investment by the cost of that investment. For instance, an investment with a profit of $100 and a cost of $100 would have an ROI of 1, or 100%, when expressed as a percentage. Although ROI is a quick and easy way to estimate the success of an investment, it has some serious limitations. ROI fails to reflect the time value of money, for instance, and it can be difficult to meaningfully compare ROIs because some investments will take longer to generate a profit than others. For this reason, professional investors tend to use other metrics, such as net present value (NPV) or the internal rate of return (IRR).
What Industries Have the Highest ROI?
Historically, the average ROI for the S&P 500 has been about 10% per year. Within that, though, there can be considerable variation depending on the industry. During 2020, for example, many technology companies generated annual returns well above this 10% threshold. Meanwhile, companies in other sectors, such as energy companies and utilities, generated much lower ROIs and, in some cases, faced losses year-over-year. Over time, it is normal for the average ROI of an industry to shift due to factors such as increased competition, technological changes, and shifts in consumer preferences.
The Bottom Line
Return on investment (ROI) is a metric that investors often use to evaluate the profitability of an investment or to compare returns across multiple investments. It is expressed as a percentage. ROI is limited in that it doesn’t take into account the time frame, opportunity costs, or the effect of inflation on investment returns, which are all important factors to consider.
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