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What is a Return On Investment?
What’s important to know about it?
In this article, I will break down the meaning of Return On Investment so you know all there is to know about it!
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What Is Return On Investment
Return on investment, commonly referred to as ROI, refers to a performance metric used to assess the profitability of an investment or compare various investment options.
As the name suggests, the return on investment provides assesses how much your investment will give you in “returns”.
An investment option with a higher return on investment is better than one with a lower return on investment.
The return on investment is calculated by taking all of the cash or benefits you get from an investment and you divide that by the amount invested.
For example, if you invested $100,000 and your investment returned $110,000, you have effectively made a 10% return on investment ($10,000 / $100,000).
If an investment provides you with positive returns, the return on investment percentage will be positive.
However, if an investment generates losses, your return on investment percentage will be negative.
Keep reading as I will further break down the return on investment and tell you how it works.
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Why Is Return On Investment Important
The return on investment is an important performance measure that is regularly used by investors, businesses, and analysts.
Calculating the return on investment allows you to quickly assess the overall profitability of a business or an investment.
For example, if you had to choose between Investment A where you put $10,000 and make $5,000 and Investment B where you put $50,000 and make $10,000, you can quickly assess that Investment A offers a higher return on investment than the second one.
Another reason why return on investment is important is that it is a highly versatile measure.
You can use it in many different situations such as assessing the profitability of an investment, compare investments with one another, or use as a benchmark to make business decisions.
Since the ROI is so easy to calculate, it is often used in business to make decisions and assess business options.
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How To Calculate Return On Investment
You can easily calculate the return on investment by using the following formula:
Return on Investment = (Investment Value – Cost of Investment) / Cost of Investment
As you can see from this formula, you will need to determine what is the value of your investment and investment cost to calculate ROI.
For example, if you had an investment option where you had a $300,000 return based on an investment cost of $250,000, your return on investment will be 25% [($300,000 – $250,000) / $250,000].
In situations where the investment provides you with a return in the future, you may want to calculate your investment return by calculating the net present value of your future cash flows.
You can use other methods to calculate the return on investment such as calculating the real rate of return, annualized ROI, net present value, return on asset, or return on equity.
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Advantages of Return On Investment
There are several advantages to using return on investment to assess the profitability of a business or investment.
The first advantage is that it is really simple to calculate.
All you need to know is how much are you investing and how much your investment is going to generate in returns.
Companies can easily obtain the input data to calculate the return on investment per product line, department, territory, business as a whole, and so on.
The second advantage of using ROI is that the results are relatively easy to interpret.
If you have a high positive number, you have a much more profitable investment than having a high negative number.
In addition to these advantages, the return on investment is a versatile profitability measure that can be used alongside many other financial ratios and measures.
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Disadvantages of Return On Investment
Although the return on investment has important advantages, you should be mindful of its disadvantages.
The most important disadvantage of return on investment is that you can easily make a mistake if your input data is not accurate or wrong.
If you cannot properly determine an investment’s return, then the return on investment measure will not be accurate.
Also, depending on the complexity of the investment, it may not be easy to calculate all the possible costs and potential returns.
For example, a company may calculate a certain cost to develop and launch a new product but in reality, unexpected costs, changes in interest rates, and other factors lead to significantly reducing the return of an investment.
Another major disadvantage is that the ROI metric can be easily manipulated to tell the story that you want it to tell.
In some cases, business managers or investment managers will present a return on investment measure by disregarding certain expenses or costs and inflating potential returns.
In addition, looking at the ROI alone may not give a good and fair representation of an investment as it does not consider the investment holding period for example.
The ROI should be considered along with other performance metrics.
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Return On Investment Example
Let’s look at an example of return on investment to better understand how it is used.
In this example, let’s look at an investor assessing the profitability of a stock investment.
The investor is looking to buy 1,000 shares of Company ABC at $50 per share.
Company ABC will pay a $4 dividend per share, per year.
The investor predicts that the stock price will go up to $60 by next year.
Let’s assume we do not use net present value methods or the impact of taxes in this example and let’s calculate the value of the investment.
The 1,000 shares will be worth $60,000 and there will be a $4,000 dividend payout.
In total, the investor will have $64,000 by investing $50,000, representing a return on investment of 28%.
A company is looking to launch its product in a new market.
It estimates that it will cost $1,000,000 to have the product distributed, marketed, and sold in this new market.
In return, it is expecting to generate $1,200,000 in revenues.
This is a 20% return on investment.
It also has an option to invest $5,000,000 to acquire a company currently established in the new market.
With the acquisition, the company will be able to distribute its product and earn profits from the target’s business operations.
It expects to generate $8,000,000 in revenues through the target company.
This investment option will generate a return on investment of 60%.
Based on this calculation, the company should acquire the target company rather than launch the product by itself.
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Return On Investment FAQ
How do you calculate return on investment?
To calculate the return on investment, you will need to find the value of your investment or how much you expect to generate and calculate your cost.
You should take the current value of your investment, subtract the cost of your investment and divide the result by the cost of your investment.
What is a good return on investment?
Just like many other financial ratios, a “good” return on investment depends on the circumstances of an investment.
You will need to consider your risk tolerance, investment time period, and other variables to see if a return is good or not.
For example, if you had the option of earning 10% over a 1 year period in a highly volatile investment versus 15% over a two-year period in a less volatile investment, you will choose based on your risk tolerance.
Also, if you had an investment that generated 8% quickly versus another that generated 10% over a longer period of time, you may prefer investing at a rate of 8% and getting your money return faster.
Can the return on investment be negative?
Yes, the return on investment can be negative when the investment generates losses.
For example, if you invest $100,000 and the ending value of your investment is $80,000, you will have a negative 20% return.
This is because you lost $20,000 on your original $100,000 investment.
What are the limitations of return on investment?
Return on investment has several limitations, such as:
- You may not account for all the costs or returns of an investment leading to inaccurate results
- The ROI does not assess the holding period of an investment
- It does not assess the risk of an investment option
- It may favor short-term investments over long-term investments
- The figure can be manipulated through accounting policies and calculations
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So there you have it folks!
What does return on investment mean?
In a nutshell, the return on investment or ROI is a financial ratio allowing you to calculate the returns on a particular investment.
The return on investment is probably one of the most commonly measured performance metrics in business.
Companies can easily get the input data they need from their financial statements to calculate return on investment.
The higher the ratio, the more you can expect to gain from the investment (and vice versa).
There are multiple ways of calculating ROI, you can calculate this metric on virtually any investment option, and it is universally understood around the world.
Now that you know what is the return on investment and how it works, good luck with your research!
I hope you enjoyed this article on Return On Investment! Be sure to check out more articles on my blog. Enjoy!
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