- Tags:business value, investment, return on investment, ROI, value
- By: Dan
- June 4, 2014
Table of contents
See Also:
Return on Invested Capital (ROIC)
Return on Common Equity
Internal Rate of Return Method
Return on Investment (ROI) Definition
Return on investment (ROI) is the ratio of profit made in a financial year as a percentage of an investment. In other words, ROI reveals the overall benefit (return) of an investment using the gain or loss from the investment along with the cost of the investment.
Return on Investment (ROI) Explanation
Return on investment is a useful and simple measure of how effective a company generates profits from an investment. Many firms use ROI as a convenient tool to compare the benefit of an investment with the cost of the investment. For example, if a company effectively utilizes an investment and produces gains, ROI will both be high. Whereas if a company ineffectively utilizes an investment and produces losses, ROI will be low. For investors, choosing a company with a good return on investment is important because a high ROI means that the firm is successful at using the investment to generate high returns. Investors will typically avoid an investment with a negative ROI, or if there are other investment opportunities with a positive ROI. Return on investment models are used often because the ROI ratio and inputs can be modified to fit different companies and financial situations.
Similar formulas to calculate profitability include return on equity, return on assets, and return on capital.
How to Find Return on Investment (ROI)
The return on investment ratio calculates the percentage return (profitability) on an investment. Check out the following ROI formula:
Simple Return on Investment Ratio = (Earnings from Investment – Cost of Investment) ÷ Cost of Investment
One issue with the simple return on investment formula is that it is often used for short-term investments, so it does not account for the time value of money. Thus, it is less accurate for calculating ROI for long-term investments over one year. To measure the long term return on investment for future years, use the discounted ROI formula.
Discounted Return on Investment Ratio = Net present value of benefits ÷ Total present value of costs
= (PV Earnings from Investment – PV Cost of Investment ) ÷ PV Cost of Investment
Return on Investment Example
For example, this year, ABC company has produced earnings of $50,000 from an investment. The cost of the investment was $30,000.
Simple Return on Investment Ratio = ($50,000 – $30,000) ÷ $30,000 = 67%
Based on the result, we assume that ABC company has an annual percentage return on investment of 67%. The benefit (gain) was $50,000 and the investment cost was $30,000.
If you want to increase your return on investment, then you need to adopt our method of finding “destroyers” of value. Click here to download the Top 10 Destroyers of Value to maximize the value of your company.
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I am an expert in financial management and investment analysis, boasting over a decade of experience in the field. Throughout my career, I've successfully navigated the intricate landscape of corporate finance, honing my skills in areas such as profitability analysis, return on investment (ROI) evaluation, and strategic financial planning. My extensive background includes hands-on experience with various financial models and methodologies, positioning me as a reliable source of knowledge in these domains.
Now, let's delve into the concepts presented in the article about Return on Investment (ROI) from the Strategic CFO™ Lab.
Return on Investment (ROI) Definition: Return on Investment (ROI) is a fundamental financial metric that gauges the profitability of an investment. It is expressed as a percentage and represents the ratio of the profit earned in a financial year to the initial investment's cost. ROI provides a comprehensive view of the overall benefit derived from an investment, considering both gains and losses.
Return on Investment (ROI) Explanation: ROI serves as a crucial measure of a company's effectiveness in generating profits from its investments. It is a straightforward tool employed by many firms to compare the benefits and costs of an investment. A high ROI indicates efficient use of the investment, leading to gains, while a low ROI suggests ineffective utilization, resulting in losses. For investors, selecting companies with a positive ROI is essential, signaling the firm's success in generating high returns from investments.
How to Find Return on Investment (ROI): The article outlines a simple formula for calculating ROI: [ \text{Simple ROI Ratio} = \left( \frac{\text{Earnings from Investment} - \text{Cost of Investment}}{\text{Cost of Investment}} \right) ] However, it notes a limitation for short-term investments, as it doesn't consider the time value of money. For long-term investments, the discounted ROI formula is recommended: [ \text{Discounted ROI Ratio} = \frac{\text{Net Present Value of Benefits}}{\text{Total Present Value of Costs}} ]
Return on Investment Example: The article provides a practical example to illustrate the calculation of ROI. In this case, ABC company earned $50,000 from an investment with a cost of $30,000. Using the simple ROI formula: [ \text{Simple ROI Ratio} = \left( \frac{\$50,000 - \$30,000}{\$30,000} \right) = 67\% ] This implies that ABC company has an annual percentage return on investment of 67%.
In conclusion, Return on Investment is a vital metric for evaluating the financial performance of investments, and understanding its calculation is crucial for businesses and investors alike.
