In short:
Return on investment (ROI) is a financial performance ratio used to measure the total percentage return of an investment. This ratio aims to measure profitability and can be used for comparison against other potential investments.
ROI is calculated by dividing the total return of an investment by the initial investment cost. It is important to note that ROI is the return over the entire life of an investment and therefore does not account for the time value of money.
Key Points
- Return on investment (ROI) measures the percentage return of an investment over the entire investment period.
- ROI is generally easy to calculate and widely understood as a measure of profitability.
- To calculate ROI, divide the nominal return of the investment by the nominal investment cost.
- ROI does not account for the time value of money, therefore, it should not be confused with the annualized rate of return.
In-depth:
Understanding ROI and How to Calculate
When looking for a quick gauge of how well a particular investment has done, return on investment (ROI) is often a popular ratio of choice. Rather than potentially needing to dig into the intricacies of multiple investments, an investor or manager at a company can simply compare ROIs for a high-level overview.
By having a quick means to sift investments based on performance, investors or company managers can better choose where to spend their time, attention, and effort. Investments with a high ROI are likely to be worth more time and resources since they’re likely to produce a profit. On the other hand, investments with a negative ROI are likely ones to avoid as they are likely to produce a loss.
Straightforward calculation
Part of the reason ROI is widely understood and accepted is likely due to how easy it is to calculate. To calculated ROI, subtract the initial cost of the investment from the current value of the investment then divide that value by the initial cost of the investment. Below is the formula:
ROI = (Current Value of the Investment – Initial Cost of the Investment) / Initial Cost of the Investment
Weak spots
Unfortunately, like with any simple calculation in finance, it is open to weaknesses. The first and arguably biggest weakness of ROI is that it does not account for the time value of money. That is, money today is worth more than money tomorrow.
What this means is that an ROI of 35% is not necessarily the same as an annual return of 35%. Maybe a more illustrative example would be to say that an ROI of 35% over two years is not equivalent to (35% / 2) or a 17.5% annual return. If an investor or company manager wanted to know the annual return of an investment they would need to turn to the internal rate of return (IRR) which captures the effects of compounding and the time value of money.
Regardless, ROI can still be a useful quick reference point as long as the next question is how long did it take to produce the ROI.
The second biggest weakness of ROI is that it can be easily manipulated. For example, if we are looking at the ROI of a project and a few non-meaningless expenses are not factored into the calculation then the ROI may appear bigger than it actually is.
Example ROI Calculation
To understand how ROI works a bit better we can take a look at an example calculation.
Let’s say we are in the market to buy a rental property. After doing enough research and searching the market we identify the property we want to buy, a small single-family rental (SFR). This property can be bought for $150,000 and will produce us $15,000 free cash flow per year.
Fast forward 5 years and the SFR market has gotten hot, so we decide we want to sell our SFR. Putting it on the market we’re able to sell it for $215,000. What’s our ROI?
One way to calculate ROI in this instance would be to subtract $150,000 from $215,000 then divide by $150,000. Here’s the result:
($215,000 – $150,000) / $150,000 = ROI
ROI = 43%
However, this is not exactly correct as we did not account for the $15,000 per year, we made over the 5 years. Taking the $15,000 per year into account our ROI calculation would look like this:
[($215,000 + $75,000) – $150,000] / $150,000 = ROI
ROI = 93%
This 93% value is the most appropriate ROI indicating that we nearly doubled our initial investment over 5 years.
*assumes we paid cash, no extended vacancies, or major expenses.
Variations of ROI
Despite being the most widely used method of calculating ROI, the method we used above is not the only way of calculating ROI. Below are a few different methods of calculating ROI that may be used in different situations.
Capital Gains Method
The capital gains method is the most common method of calculating ROI and the initial method we used above. To calculate ROI using the capital gains method, divide the difference between the current value of the investment and its initial value by its initial value.
(Current Value – Initial Value) / Initial Value
Net Income Method
Say in the example above we didn’t sell the property and did not want to consider its appreciated value in calculating our ROI. We could still calculate the ROI via the net income method. To do this we would divide the total net income received from the property by the original investment amount.
Net Income / Initial Investment
Total Return Method
The total return method of calculating ROI is the second approach we took above in calculating the ROI on our property. In this case, we added the total net income we received from the property to the increase in value of the property before we divided it by the initial investment.
[ (Current Value + Net Income) – Initial Value ] / Initial Value
Annualized
If we wanted to address the biggest weakness of ROI, which is it doesn’t account for time, we could annualize the ROI. This means we would look at the ROI on a per-year basis. To do this we would need to raise the ending value divided by the initial value to the power ( 1 / # Years ) then subtract 1 from the result.
[ (Current Value / Initial Value)^( 1 / # Years) ] – 1
Frequently Asked Questions
What is an ROI example? Consider you bought a stock at the beginning of the year for $50 and by the end of the year, the stock was worth $75. Your ROI in this example would be 50%, ( $75 – $50 ) / $50, assuming no dividends were paid.
The best returns on investments will always be positive and at least 10% per year since this is the long-term average return of the general stock market. Investments that can consistently annualize returns of 15% or greater are exceptional.
Return on investment (ROI) is a financial performance ratio used to measure the total percentage return of an investment. This ratio aims to measure profitability and can be used for comparison against other potential investments.