Last Updated on Aug 25, 2022 by Aradhana Gotur
When you invest in security, you want to know the returns that you may get on your investment. After all, the primary goal of investing is capital appreciation.
The parameter of assessing the performance of a particular instrument is the returns generated. This is where the concept of return on investment comes into the picture. Let’s understand this in detail.
Table of Contents
What is return on investment?
In simple terms, return on investment (ROI) is the returns that you have earned from your investment. The ROI is denoted in numerical terms and measures the absolute returns that you have earned over the investment period. ROI is measured against the cost of investment, much like you measure profits.
For example, say you invested Rs. 1 lakh in an instrument, and your investment has grown to Rs. 1.25 lakh. Then, the ROI, in this case, would be 25%. This is the simplest way to calculate returns. However, there are many factors that influence the actual ROI. Real-life investment and returns may not be as straightforward.
Measuring ROI
The return on investment formula is a simple mathematical expression to calculate the ROI of an investment. If you look at the above example, the ROI formula would become evident. It is as follows:
ROI = {(Current value of the investment – the cost of the investment) / The cost of the investment} x 100
If we incorporate the ROI formula in the above example, ROI would be calculated as follows:
ROI = {(1,25,000 – 1,00,000) / 1,00,000} x 100
= (25,000 / 1,00,000) x 100
= 25%
Note: Should you have incurred any additional expense when investing in an instrument, the expense should be added to the investment cost when calculating ROI.
For example, say you bought a real estate property at Rs. 50 lakh and paid a brokerage of Rs. 5 lakh on the same. So, the cost of investment would be calculated as Rs. 55 lakh since the brokerage cost would be added to the cost of the property.
Uses of ROI
The ROI is simple to calculate, and it gives you an insight into the absolute return that you have earned from an investment avenue. It can, thus, be used for the following:
- To have an overview of how your investment has performed against market standards. This can help you make investment decisions on whether to hold onto the investment or to sell it off for better choices.
- ROI can be used to compare different investments of similar categories. For instance, you can compare the ROI of two different stocks to know which is performing better.
- Negative ROIs help you find the subpar performing instruments thus helping eliminate them from your portfolio.
- ROI is also used to gauge the profitability of projects.
- Since the investment cost includes the cost of brokerage, commission, or improvements, you get a holistic ROI figure that shows the actual returns earned.
Limitations of ROI
While ROI is a simple metric and easy to calculate, it has its limitations too. The primary limitation is that the ROI formula does not use the time element in its calculation. Though you get the absolute figure, the time value of money is ignored.
ROI does not tell you the annual return that you have earned from your investment. Even if, in some years, the returns were negative, the overall ROI might be positive, giving a false picture.
For instance, say you invested in a stock for five years. For the first two years, the stock gave positive returns. However, in the third year, the stock’s value plummeted, and you suffered a loss. But the loss was recovered in the next couple of years. When calculating ROI, you take the original purchase price of the stock at which you invested and the current price. The price fluctuation during the investment horizon is ignored. This is where the ROI falls short.
To measure effective returns, which are time-sensitive, other parameters are used, like the Internal Rate of Return (IRR) or the Net Present Value (NPV). These parameters accommodate the time value of money and thus give more accurate figures.
Should you use ROI?
Though ROI has a time limitation, it can be easily overcome by annualising the return on investment formula. The new ROI formula would then be as follows:
Annualised ROI = [{(1 + ROI) ^ (1/n)} – 1] x 100
where ‘n’ is the investment tenure.
So, suppose an investment of Rs. 1 lakh becomes Rs. 1.5 lakh after five years, the ROI can be calculated as follows:
ROI = {(1,50,000-1,00,000) /1,00,000} x 100
= (50,000 /1,00,000) x 100
= 50%
And the annualised ROI would be calculated as follows:
[{(1+0.5)^(⅕)} – 1] x 100
= 8.45%
So, while the investment gave you an absolute ROI of 50%, the annualised ROI stands at 8.45%. Thus, you can use the annualised return on investment formula to compare different investments and choose one that offers the highest returns.
Conclusion
The concept of return on investment is not difficult to understand or calculate. It gives you the basic return you have earned from an investment and can be used as a ready-reckoner to gauge how your investments are performing. The annualised version of the ROI is a good way to assess the annual returns. So, understand what ROI is all about and then use the metric to review your portfolio at regular intervals.
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