Return on Investment: What is ROI, Its Formula, Uses, Benefits and More

Return on Investment: What is ROI, Its Formula, Uses, Benefits and More

Return on investment (ROI) tells you how much money you have made or lost on an investment after considering all the costs.

ROI is a measure of the performance of an investment – it compares the income made on an investment and the cost you’ve incurred to measure its profitability/performance with other investments.

ROI is usually expressed as a percentage, making it an effective comparison between investments. It is also related to measures such as return on equity (ROE), which can be used in tangent to ROI, amongst other measures, to ascertain the profitability of investments. ROI can also be used to analyse how well a certain index, company, or industry has performed.

How to calculate Return on Investment

ROI formula:

Alternatively, it can also be calculated using the following formula to ascertain profit:

Thus, return on investment is a concept that can help you understand what real gains you have made from your investments in real time and compare that with other gains.

How to use ROI

There are multiple ways you can use the ROI concept; some of them are explained below:

Businesses

Return on Investment is calculated for a range of financial investments. For example, a business may use it to calculate the long-term monetary benefits of investments in machinery, advertising projects, and technology, among others.

Share Market

One of the key aspects of understanding investing is understanding the ROI in the share market and how to use it. In the share market, ROI can be used to measure the capital appreciation or rise in the value of investments.

Not only can it help measure current returns, but it can also help to predict returns on the purchase of shares based on its track record. By analysing a stock’s past performance based on ROI, an investor can expect returns it may give in the future. Although this is not the most accurate measure (because it does not consider the time value of money), it is still an easy way that can be used by beginners and experts, taking into account risk. For example, a $100 investment in a share yielded $130 in income from sale a year later, this would translate to a 30% ROI.

Benefits of ROI

ROI is a universal measure of profitability – used across the world due to its ease of calculation. So, the chances of someone misunderstanding its meaning because of different cultural contexts are difficult. Plus, it is a versatile metric – it can be used for different purposes. But most importantly, ROI is an easy tool for beginner investors to help them gauge the state of their finances and get an idea about what to expect from their investments.

Limitations of ROI

One of the biggest limitations of ROI is that it does not consider the time value of money and inflation. The concept focuses on comparing profits with costs expressed as a percentage, not considering how much time your capital is invested in it. The risk factor is also not considered in ROI calculations – how much risk, uncertainty, and distribution of risk the investment has.

Aspects such as these make ROI difficult to utilize in complex or technical calculations. Still, it can also be a precursor to such calculations to ascertain the question of whether the investment is worth it in the most basic and efficient way.

FAQs

Some frequently asked questions about ROI and their answers include:

Can ROI be used on all investments?

If you have the figures needed to calculate it (net income and net cost), then you can calculate and compare ROI for any investment.

How do you know an ROI is good?

Although there is no hard and fast rule, any ROI in the share market at or above 7 - 8% is a good figure to target.

Which investments have the highest ROI?

It depends. For risk-free investments, putting money into bonds or treasury bills can be a great long-term and safe investment. Otherwise, equity (shares) has the most scope for returns.