Return on investment (ROI) is a metric used to understand the profitability of an investment. ROI compares how much you paid for an investment to how much you earned to evaluate its efficiency. Let’s take a look at how it’s used by both individual investors and businesses.
What Is ROI?
When you put money into an investment or a business endeavor, ROI helps you understand how much profit or loss your investment has earned. Return on investment is a simple ratio that divides the net profit (or loss) from an investment by its cost. Because it is expressed as a percentage, you can compare the effectiveness or profitability of different investment choices. It is closely related to measures like return on assets (ROA) and return on equity (ROE).
How to Calculate ROI
To calculate return on investment, divide the amount you earned from an investment—often called the net profit, or the cost of the investment minus its present value—by the cost of the investment and multiply that by 100. The result should be represented as a percentage. Here are two ways to represent this formula:
ROI = (Net Profit / Cost of Investment) x 100
ROI = (Present Value – Cost of Investment / Cost of Investment) x 100
Let’s say you invested $5,000 in the company XYZ last year, for example, and sold your shares for $5,500 this week. Here’s how you would calculate your ROI for this investment:
ROI = ($5,500 – $5,000 / $5,000) x 100
Your return on investment in company XYZ would be 10%. This simple example leaves out capital gains taxes or any fees involved in buying or selling the shares, but a more realistic calculation would factor those into the cost of the investment.
The percentage figure delivered by the calculation is ROI’s superpower. Instead of a specific dollar amount, you can take this percentage and compare it to the ROI percentage of other investments across different asset classes or currencies to determine which gives the highest yield.
How to Use ROI
ROI may be used by regular investors to evaluate their portfolios, or it can be applied to assess almost any type of expenditure.
A business owner could use ROI to calculate the return on the cost of advertising, for instance. If spending $50,000 on advertising generated $750,000 in sales, the business owner would be getting a 1,400% ROI on the ad expenditure. Similarly, a real estate owner mulling new appliances might consider the ROI from two different renovation options, factoring in cost and potential rent increases, to make the right choice.
Just keep in mind that ROI is only as good as the numbers you feed into your calculation, and ROI cannot eliminate risk or uncertainty. When you use ROI to decide on future investments, you still need to factor in the risk that your projections of net profits can be too optimistic or even too pessimistic. And, as with all investments, historical performance is no guarantee of future success.
What Is a Good ROI?
According to conventional wisdom, an annual ROI of approximately 7% or greater is considered a good ROI for an investment in stocks. This is also about the average annual return of the S&P 500, accounting for inflation. Because this is an average, some years your return may be higher; some years they may be lower. But overall, performance will smooth out to around this amount.
That said, determining the appropriate ROI for your investment strategy requires careful consideration rather than a simple benchmark. The S&P 500 may not be appropriate for the level of risk you’re willing to take on or the asset class you’re investing in, for instance. To calculate the ROI that’s good for you, ask yourself the following questions:
How much risk can I afford to take on?
What will happen if I lose the money I invest?
How much profit do I need for this investment to take on the prospect of losing money?
What else could I do with this money if I don’t make this investment?
Limitations of ROI
ROI is not without limitations. First and foremost, ROI does not take time into account. If one investment had an ROI of 20% over five years and another had an ROI of 15% over two years, the basic ROI calculation cannot help you determine which investment was best. That’s because it doesn’t take into account compounding returns over time.
Annualized ROI can help avoid this limitation. To calculate annualized ROI, you need to employ a little bit of algebra. The value n in the superscript below is key, as it represents the number of years the investment is held.
Annualized ROI = {[1 + (Net Profit / Cost of Investment)] (1/n) – 1} x 100
If you bought a portfolio of securities worth $35,000, and five years later your portfolio was worth $41,000, you’d have earned an annualized ROI of 3.22%. The formula would look like this:
Annualized ROI = {[1 + (6,000 / 35,000)] (1/5) – 1} x 100 = 3.22%
Accurate ROI calculations depend on factoring in all costs, not merely the initial cost of the investment itself. Transaction costs, taxes, maintenance costs and other ancillary expenditures need to be baked into your calculations.
Finally, an ROI calculation that depends on estimated future values but does not include any kind of assessment for risk can be a problem for investors. It is easy to be tempted by high potential ROIs. But the calculation itself does not give any indication of how likely that kind of return will be. This means investors should tread carefully.
The Bottom Line
ROI is an understandable and easily calculated metric for determining the efficiency of an investment. This widely used calculation allows you to compare apple-to-apples among investment options.
But ROI cannot be the only metric investors use to make their decisions as it does not account for risk or time horizon, and it requires an exact measure of all costs. Using ROI can be a good place to start in evaluating an investment, but don’t stop there.
