Return On Investment (ROI): Meaning, Formula & Calculation
Return on investment (ROI) is a financial measurement of profitability. Entrepreneurs, businessmen, and investors use ROI as an indication of what actual return an investment realized. ROI is expressed as a percentage and is commonly used as a key performance indicator (KPI) when evaluating financial performance.
What Does Return on Investment Mean?
Return on investment is often notated as ROI. It is the ratio between the net return and the cost of the investment. Investors seek high ROIs on investments, where there exists a lot of profit relative to the capital investment.
ROI Formula & How to Calculate
Calculating the ROI requires having the details about a specific project, investment, or strategy.
The formula for ROI is simple.
ROI = ((Final Value of Investment - Initial Cost of Investment) / Initial Cost of Investment) x 100
You first subtract the initial cost of the investment from the final value. This gives you the net return. Then divide the net return by the cost of the investment and multiple the final number by 100.
Expected ROI Targets
Investors and companies can develop expected ROI targets, often based on the risk of the investment or difficulty of the project. For example, a 2% ROI on a treasury bill investment may be seen as acceptable, while a 2% ROI on the construction and development of a new mine might be seen as too low of a return, given the complexity and risk of the project.
Interim Cash Flows
Interim cash flows also play into the calculation of an ROI measure. For a stock, dividends would represent interim cash inflows, while for a company project, milestone payments are an example of interim cash flows.
Return on Invested Capital (ROIC)
There is another term that investors should be aware of: return on invested capital (ROIC) which is used by companies rather than investors. This is the ratio between the net operating profit after tax (NOPAT) and invested capital.
The formula for ROIC is:
ROIC = NOPAT/Invested Capital
Where the ROI measures how well one particular investment, project, or strategy performs, the ROIC shows how efficient the company is. A company may have a ROI determined for multiple parts of the business where the ROIC is a singular data point that evaluates how well a company allocates its capital resources.
Return on Investment Calculation Examples
Example 1:
Let's assume that the investor bought 100 shares of XYZ stock at $8 per share. The initial investment is $800. If the stock rose to $10 per share and the investor sold it, the final value of the investment is $1,000. Using the formula, this represents a 25% ROI.
($1,000 - $800)/$800 x 100 = 25%
Example 2:
If a company spent $10,000 on a new advertising campaign that resulted in $50,000 in sales. The ROI (on a sales basis, not net profit) would be 400%.
[($50,000 - $10,000) / $10,000) X 100] = 400%
The higher ROI that a company can generate on a project, the more attractive it is to consider, adjusted for risk.
Key Takeaway: There are no universal standard expectations for Return on Investment. An ROI of 10% might be seen as acceptable for one project/investment but unacceptable for a different project/investment.
Benefits of Using ROI
Investors and business owners are well served using ROI as a measurement for success and profitability.
- It allocates the net income to a division or project to demonstrate whether or not the company should continue to allocate resources in that area.
- It can be used in comparative analysis, helping to see which investment areas are yielding the biggest returns. This helps investors choose the right investments to make.
- Calculations are easy to perform, especially in cases where there are no interim cash flows. For an investor, ROI can be calculated using the market value of a holding, as well as the cost basis for that holding as tracked within their brokerage account. For companies, accounting data can be used to calculate various ROI measures.
Limitations of Using ROI
Limitations of ROI include:
- It can be calculated in various manners. For instance, the net return can be measured as net profit, EBIT, or in some cases even sales. For ROI measures to be meaningful indicators across different companies, evaluators must make sure to use a common definition of ROI.
- It doesn’t take into consideration the length of the investment. A 100% ROI might sound vastly superior to a 20% return, but if it took 5 years to generate the 100% return but only 1 month to generate the 20% return, the picture looks a lot different. Many investors track annualized returns, which help translate multiple ROI measures from various holding periods into a number that's more suitable for comparison.
- Doesn't account for intangible benefits. From a business perspective, solely relying on ROI may result in division leaders ignoring projects with intangible benefits that can't as easily be tracked. This could result in company management having a skewed sense of what brings value to the company.
Tip: Many ROI numbers are reported using annual data. For those that aren't, an evaluator can convert ROI numbers into annualized percentage returns.
Bottom Line
Using return on investment (ROI) measures, investors and business leaders are able to assess the success of an investment or expenditure. The higher the ROI, the higher the realized profit. Investors should be leery of investments promising an extremely high ROI and should do further due diligence on the company to determine if it is realistic.
This article was written by
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