Return oninvestment(ROI) is a financial metric that helps understand the profitability of an investment. It calculates your returns against the initial investment costs, helping you determine the percentage of profit you made on your investment and helping you realise the true worth of your investment.
In this blog, we will delve deeper into understanding what ROI is, its types, ROI benefits and how to calculate ROI.
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What is the return on investment (ROI)?
ROI is a ratio you can derive by dividing the net profit or loss from an investment by its cost. In this sense, the return on investment helps you evaluate how much profit or loss you made on your investment. It is denoted in percentage form, and you can compare the profitability of different investment instruments using ROI methodology to gauge the right investment choice.
The ratio is often used along with other parallel ratios like Return on Equity (ROE) and Return on Assets (ROA) to truly evaluate the gains from an investment.
Return on equity: Highlights
- Return on investment (ROI) is a financial metric that allows an investor to evaluate the performance of a particular investment.
- ROI is denoted as a percentage and can be measured using a simple or annualised ROI equation.
- ROI isn’t stable, and many variables can influence it. Therefore, you must calculate this ratio regularly and make changes to your investment portfolio or business as needed.
- When the ROI is positive, it means the investment is profitable. Likewise, if the calculation shows a negative ROI, it is a potential red flag.
What is ROI used for?
ROI helps analyse investment decisions as it helps compare the outcome or return against cost. Businesses also consider the return on investment to evaluate past, present, and future investments.
With the help of a pre-defined return on investment calculator, individual investors can measure the ROI – whether it’s a stake in a startup or a stock holding – against others in their investment portfolio.
How to calculate return on investment (ROI)?
If you are wondering how to find a return on investment, there are multiple ways to do so. The simplest method could be using the ROI formula, as stated below.
ROI = Net income / Cost of investment X 100
Here, net income refers to the net returns you gain from an investment, whereas the cost of investment refers to the amount of money you put into a specific investment instrument.
Here’s an example of the ROI formula calculation:
Let’s assume your initial investment is worth Rs. 10,000 in a company’s stock. Three years later, you want to sell the shares now worth Rs. 12,000. So, here’s how to calculate return on investment:
ROI = 12,000 – 10,000 / 10,000
This gives you a net investment gain of Rs. 2,000. This number is then divided by the cost of investment.
ROI = 2,000 / 10,000 = 0.2
0.2 X 100 = 20%
This simple return on investment formula is standard when measuring returns. However, the disadvantage of using this formula to calculate ROI is that it does not consider the opportunity cost or time period of the investments.
On the other hand, annualised ROI can provide more insights vis-à-vis the period for which you have held the investment and present a more accurate picture. Below is the annualised ROI formula:
Annualised ROI = (Ending value / Beginning value) (1/n) – 1
A = (12,000 / 10,000) (1/3) – 1
A = (1.2) (1/3) – 1
A = 0.063; A = 6.3%
As observed, the simple ROI and annualised ROI numbers are very different. The latter can offer better insights into an investment’s performance.
What is a ‘good’ return on investment?
ROI is a subjective metric. A good ROI solely depends on the investment vehicle. For instance, the average ROI in the stock market is 10% annually. By using the above-mentioned ROI formula, you can identify the % growth of your portfolio in the past year. Or, you can connect your portfolio on Tickertape and get real-time updates on ROI.
If your portfolio has outperformed and grown more than 10% per annum, you have a good ROI on your investment.
What are the advantages of ROI?
- ROI is simple to calculate and helps analyse the performance of an investment or a business.
- ROI can aid the comparison of returns from different investments.
- ROI can help make better financial decisions.
What are the disadvantages of ROI?
- Simple ROI does not consider the time period the investment is held.
- ROI doesn’t consider age or risk tolerance, the two most crucial aspects when formulating an investing strategy.
- ROI calculation may miss out on considering the actual cost, depending on the formula (like transaction costs, taxes, and fees).
- ROI calculations differ between all investors and businesses, making the comparison between investments imprecise.
What are the alternatives to ROI?
In reality, an ROI may provide only limited information. Thus, you might want to consider other ROI alternatives.
- Social ROI (SROI)
SROI is a systematic method of incorporating economic, social, and environmental values into decision-making processes. Depending on the economic value of environmental and social outcomes, one can gauge whether a business, enterprise, or development project is beneficial and profitable.
The formula is –
SROI = Net present value of benefits / Net present value of the investment
- Marketing Statistics ROI
Marketing ROI justifies how marketing campaigns and programs from different channels have performed and generated revenue for the business. These channels include social media marketing, digital marketing, and email marketing.
The calculation is as follows –
Marketing ROI = Sales growth – Marketing cost / Marketing cost
- Social Media Statistics ROI
Social media ROI signifies the value created by your investments in social media. It also proves whether or not your social media marketing strategies are effective and generating the intended results. One of the ways to calculate the time, money, and resources invested in social media is –
Social media ROI = Value / Total Investment X 100
Conclusion
Return on investment (ROI) is a common financial metric that measures returns from investments and businesses. While ROI percentage is essential and crucial, it’s also important to be aware of its limitations. Remember, ROI cannot be the only metric to make your decisions; however, it can be a good place to start evaluating an investment.
FAQs
What are the limitations of ROI?
ROI ignores the time value of money. It also doesn’t factor in different components to calculate the ROI. Moreover, it only measures the financial success of a project and doesn’t account for the non-financial benefits of an investment.
Why is ROI important in business?
ROI allows businesses to see the outcome of their investments, either in the form of a positive or negative percentage. This is important for decision-making.
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Authored By:
Anjali Chourasiya
I am a finance enthusiast who loves exploring the world of money through my lens. I’ve been dedicated to building systems that work and curating content that helps people learn.
As an insatiable reader and learner, I’ve spent the last two years exploring the world of finance. With my creative mind and curious spirit, I love making complex finance topics easy and fun for everyone to understand. Join me on my journey as we navigate the world of finance together!
I am Anjali Chourasiya, a finance enthusiast with a deep understanding of various financial concepts and metrics. Over the last two years, I have dedicated myself to exploring the intricacies of the financial world, building systems that work, and curating content to help people learn. My passion lies in making complex finance topics easy and enjoyable for everyone to understand. As an insatiable reader and learner, I have immersed myself in the world of finance to gain firsthand expertise.
Now, let's delve into the key concepts discussed in the article about Return on Investment (ROI).
Return on Investment (ROI): ROI is a crucial financial metric that assesses the profitability of an investment by calculating the returns against the initial investment costs. It is expressed as a percentage and aids in determining the profit percentage made on an investment. ROI is commonly used alongside other ratios like Return on Equity (ROE) and Return on Assets (ROA) to comprehensively evaluate the gains from an investment.
Return on Equity (ROE): ROE is a financial metric that allows investors to evaluate the performance of a specific investment. It is denoted as a percentage and can be measured using a simple or annualized ROE equation. ROE, like ROI, is not stable and can be influenced by various variables. Positive ROE indicates profitability, while negative ROE is a potential red flag.
Uses of ROI: ROI is used to analyze investment decisions by comparing returns against costs. It is employed by businesses to evaluate past, present, and future investments. Individual investors can use a predefined ROI calculator to measure the ROI of different investments in their portfolio.
How to Calculate ROI: The article provides a simple ROI formula: ROI = Net income / Cost of investment X 100. It emphasizes the importance of considering the opportunity cost and time period in investment decisions. Additionally, it introduces the concept of annualized ROI for a more accurate representation of an investment's performance over time.
'Good' Return on Investment: Determining a 'good' ROI is subjective and depends on the investment vehicle. The article suggests that if a portfolio has grown more than the average ROI in the market, it can be considered a good ROI.
Advantages of ROI: ROI is praised for its simplicity in calculation and its effectiveness in analyzing investment or business performance. It facilitates the comparison of returns from different investments, aiding in better financial decision-making.
Disadvantages of ROI: The article highlights that simple ROI may overlook the time period of investment, age, and risk tolerance, crucial aspects in formulating an investment strategy. It may also miss considering actual costs like transaction costs, taxes, and fees.
Alternatives to ROI: The article introduces Social Return on Investment (SROI) as a method incorporating economic, social, and environmental values into decision-making. It also mentions Marketing ROI and Social Media ROI as alternatives to assess the performance of marketing campaigns and social media investments.
Conclusion: The conclusion emphasizes that while ROI is a significant metric, it should not be the sole factor in decision-making. It encourages considering other metrics and alternatives to gain a comprehensive understanding of an investment's performance.
FAQs: The FAQs section addresses the limitations of ROI, emphasizing its neglect of the time value of money and its exclusive focus on financial success. It also explains the importance of ROI in business decision-making.
In summary, the article provides a comprehensive overview of ROI, its calculation, uses, advantages, disadvantages, alternatives, and concludes with the importance of considering multiple metrics in financial decision-making.
