What is Return on Investment (ROI)? All you need to know

This article guides and provides broad information about Return on Investment (ROI).

Return on Investment or ROI is the increase or decrease percentage of an investment within a year. Investors, business owners, and entrepreneurs use ROI to determine the actual profitable returns an investment yields.

What is Return on Investment (ROI)

What is Return on Investment?

Return on investment is a financial metric to measure the probability of profits from an investment. It is the ratio that checks compare profit and losses from an investment relative to its costs.

ROI is valuable in knowing potential profits from an investment. With this investors can evaluate their investment and determine their performances If an investment yielded more returns than others. As an investor or entrepreneur, when you invest Return on Investment helps you to better understand profits and losses made in an investment.

ROI is expressed in percentage, which enables you to compare the profitability and effectiveness of various alternative investments.

In some situations investing to make a good return on investment can be risky, as there are risks of making a negative ROI. Most investors and business owners search for a more efficient investment with a good ROI.

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Calculating ROI ( four different methods)

There are various methods to calculate ROI, each with its special purpose. Investors and entrepreneurs calculating profitable returns on investment use one of these methods, depending on their preferences. 

1. Net Income Method

The basic formula for net income is quite simple to apply. All you are required to know is the value of the cost invested and the total revenue value from the investment.

ROI ={Revenue/Cost}×100%

A clear example. Revenue:$7,000 Cost:$5,000.

ROI={$7,000/$5,000}/100 =140% ROI.

2. Capital Gain Method   

Being an investor this method enables you to calculate your ROI. ROI ={Revenue-Cost}/Cost ×100.

ROI={$7,000-$5,000}/$5,000×100=40% ROI.

3. Total Return Method 

This method enables investors to calculate ROI in shares. ROI =(Current share price + Total dividends received – Original share price)/Original price×100.

ROI= (15+1.5-10)/10×100=65%.

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4. Annualized ROI 

Investors and entrepreneurs can use this method to calculate ROI, which considers the time interval of investment on an annual basis. This formula is a bit more complicated than the rest. As an investor you are ought to calculate your capital gain ROI and be aware of the number of years the investment is held.

ROI=[((1+Capital gain ROI)^1/n)-1]×100. The n represents the number of years the investment is held.

ROI=[(1+0.4)¼-1]×100=8.7%. These formulas are sometimes too flexible and can be applied in different forms. ROI can be simple and complex most of the time.

Return On Investment Formulas (Best Steps In Calculating)

If you are not familiar with how to calculate ROI, then follow these simple steps.

In ROI, there are Revenue, Cost, and ROI percentage. Revenue is the totThe amount consists of your invested cost and returns, while Costs are the money you invested. We will attend to the ROI percentage at the end.

First, subtract the cost from the revenue, which gives you the “net return”. Once you know the values for net profit, divide it by the cost and multiply the given value by 100.

ROI=(Revenue-Cost)/Cost×100. This gives you the ROI percentage. Return on Invested Capital (ROIC) is another term investors are to be aware of. Return on invested capital is a preference for companies, and not for investors.

ROIC is the ratio between the Net Operating Profit After Tax (NOPAT) and invested capital. ROIC formula is expressed as ROIC=NOPAT/Invested capital.

How To Calculate ROI

As an investor or entrepreneur, let us assume you bought 100 shares at $5 per share your total investment cost is $500. Lucky if the stock were to rise to $7 per share and you decide to sell the shares, your investment value is $700 which indicates profitable returns.

To evaluate your returns on investment percentage, use the formula. ROI=(Current total share price-Initial total share price)/Initial total share price ×100. ROI=($700-$500)/$500×100=40% ROI. This simply implies you made a 40% ROI, which is considered a profitable ROI on all investments.

The same step applies to an investor that invested $1,000 and after a year the investment yields a return of $1,300. With these simple steps ROI formula, investors can evaluate their ROI percentage. ROI=( $1,300 -$1,000)/$1,000×100 = 30% ROI.

Investors and companies can set up an expected ROI target, which is mostly dependent on the risk of the investment or the difficulty of the project. 

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What Is ROI Used For?

Investors and business owners can use ROI to evaluate various investment decisions, comparing investment plans on ROI and initial investment cost. This helps investors to choose profitably one investment over another. Enterprises also evaluate future investment using ROI calculations. This is done to avert any financial setbacks. 

What Is a Good ROI?

Going by Conventional Wisdom statistics 7% and above as annual ROI is considered a good ROI for a stock investment. This also involves the average annual return of the S&P 500, which accounts for inflation.

Return On Investment Calculation Example

For instance, let us assume a company spent $20,000 on a new advertising campaign, which yielded a return of $100,000 in sales. Calculating the ROI is simply done by. ROI=($100,000-$20,000)/$20,000 × 100 = 400% ROI.

This is a very huge ROI percentage. A company with a higher ROI generated on a project attracts more investors and entrepreneurs.

Benefits Of Using ROI

ROI fulfilled its high expectations to estimate profitability and success on investments. ROI distributes the net income to a project to show if a company should continuously allocate its resources to a particular project.

One of the major benefits of return on investment is, it can be used in helping investors and entrepreneurs to analyze investment areas generating huge returns. This is quite effective in assisting investors to make the best choice on investments. 

Calculating ROI is simple, based on the easy steps involved. For business owners, calculating ROI is an easy task using market value holding.

Limitations Of Using ROI 

Being able to be calculated in different methods is one of the limitations of ROI. Let us assume a situation where the net return can also be measured as the net profit or in most cases, sales.

Furthermore, ROI does not consider the period of an investment, which has been pointed out as a disadvantage. Let us assume a 100% ROI which is enticing and fat better than a 20% ROI.

If the period to generate 100% ROI is 5 years and a month to generate 20%. The basic ROI calculation might make it difficult for you to ascertain which investment was the best.

Interpreting Return On Investment (ROI)

Most amateurs who want to venture into investment will usually ask “what is return on investment”?. These questions demand a satisfying answer but most especially interpreting ROI will give a better understanding.

The simple definition of ROI remains, that ROI is a metric commonly used to measure profit and losses an investment generates relative to the invested cost. 

So interpreting ROI gives comprehensive details about investments that are profitable or non-profitable. The equations in ROI use “net return” rather than “net profit” this is commonly used because most investments can yield a negative return instead of the expected positive return.

This takes us to the black and red represents positive and negative returns on ROI in an investment. If your ROI is positive, it implies that you are in the black, an indication signifying your total returns are greater than your total cost.

In a situation where you have a negative ROI, which directly implies you are in the red and your total return are less than your total cost. This is bad business for you because the reason you invested was to make a good return rather than no return at all.

Some questions like “what is a good ROI are still widely asked. It strictly depends on your business and industry.

As an investor, 15% ROI is considered a good rate. For investors in the digital market, an incredible 118% is the average ROI.

The percentage value above shows the huge differences in ROI, which digital marketing has the highest rate. Investors and business owners should not randomly choose investments. Knowing your industry standard is important.

Benefits and Downsides of using ROI

ROI is the easiest measurement of the percentage of profits from an investment and it consists of many benefits.

  • Easily to calculate 
  • Aids investors set goals for the present and future projects 
  • It is easy to understand both experts and amateurs
  • Guides investors to predict potential future returns 
  • Effective to measure projects success 
  • It helps in choosing a different investment opportunity, providing plain numbers in making a good decision 
  • It can be used to calculate and compare previous returns which aid investors to examine an investment’s previous ROI rate and performances if they are potential investments to consider.

ROI can help investors in making investment decisions, to determine the best investment with profitable returns. One major downside in calculating ROI is the time factor, excluding annualize return method. As a result of possessing many different formulas in calculating ROI, most times it turns out to be confusing.

Assuming a company calculates its ROI with a particular formula, an investor, on the other hand, may use a different formula to calculate and by so doing results to obtain a different percentage. This results in some sort of confusion between companies and investors.

To avoid such confusion occurring, the company and investors are to use the same formula to calculate

ROI.   

Importance of ROI 

Investors and entrepreneurs are always eager to expand the growth of their businesses financially. ROI is frequently used to evaluate the profitability of an outlay. It analyzes the prospect of success in any business over a period, and decision making on potential investment preferences.

The ability to calculate ROI is of great value to any enterprise irrespective of industry or size. Knowing that your invested funds are likely to yield good returns is a relief and a possibility of financial expansion.

Being an investor or entrepreneur, you can calculate your ROI perfectly. You have a better understanding of how your business is making progress, and areas that require urgent attention to improve financially. Developing this business strategy will significantly help in achieving your financial goals.

Conclusion

To have a broad knowledge about ROI exposes you to potentially profitable investments. Investors and business owners should beware of investment with questionable ROI.

Securing financial freedom is a top priority for investors and entrepreneurs alike, not just that, but also choosing the best ROI percentage on all investments.

Despite the limitations of ROI which is not time considered on returns, ROI is still helpful in evaluating an investment.

References:

  • https://seekingalpha.com/article/4475210-what-does-roi-mean
  • https://www.investopedia.com/terms/r/returnoninvestment.asp
  • https://www.techtarget.com/searchcio/definition/ROI

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