Return on investment (ROI) is a financial metric that helps understand the profitability of an investment. It calculates your returns against the initial investment costs, helping you determine the percentage of profit you made on your investment and helping you realise the true worth of your investment.
In this blog, we will delve deeper into understanding what ROI is, its types, ROI benefits and how to calculate ROI.
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What is the return on investment (ROI)?
ROI is a ratio you can derive by dividing the net profit or loss from an investment by its cost. In this sense, the return on investment helps you evaluate how much profit or loss you made on your investment. It is denoted in percentage form, and you can compare the profitability of different investment instruments using ROI methodology to gauge the right investment choice.
The ratio is often used along with other parallel ratios like Return on Equity (ROE) and Return on Assets (ROA) to truly evaluate the gains from an investment.
Return on equity: Highlights
- Return on investment (ROI) is a financial metric that allows an investor to evaluate the performance of a particular investment.
- ROI is denoted as a percentage and can be measured using a simple or annualised ROI equation.
- ROI isn’t stable, and many variables can influence it. Therefore, you must calculate this ratio regularly and make changes to your investment portfolio or business as needed.
- When the ROI is positive, it means the investment is profitable. Likewise, if the calculation shows a negative ROI, it is a potential red flag.
What is ROI used for?
ROI helps analyse investment decisions as it helps compare the outcome or return against cost. Businesses also consider the return on investment to evaluate past, present, and future investments.
With the help of a pre-defined return on investment calculator, individual investors can measure the ROI – whether it’s a stake in a startup or a stock holding – against others in their investment portfolio.
How to calculate return on investment (ROI)?
If you are wondering how to find a return on investment, there are multiple ways to do so. The simplest method could be using the ROI formula, as stated below.
ROI = Net income / Cost of investment X 100
Here, net income refers to the net returns you gain from an investment, whereas the cost of investment refers to the amount of money you put into a specific investment instrument.
Here’s an example of the ROI formula calculation:
Let’s assume your initial investment is worth Rs. 10,000 in a company’s stock. Three years later, you want to sell the shares now worth Rs. 12,000. So, here’s how to calculate return on investment:
ROI = 12,000 – 10,000 / 10,000
This gives you a net investment gain of Rs. 2,000. This number is then divided by the cost of investment.
ROI = 2,000 / 10,000 = 0.2
0.2 X 100 = 20%
This simple return on investment formula is standard when measuring returns. However, the disadvantage of using this formula to calculate ROI is that it does not consider the opportunity cost or time period of the investments.
On the other hand, annualised ROI can provide more insights vis-à-vis the period for which you have held the investment and present a more accurate picture. Below is the annualised ROI formula:
Annualised ROI = (Ending value / Beginning value) (1/n) – 1
A = (12,000 / 10,000) (1/3) – 1
A = (1.2) (1/3) – 1
A = 0.063; A = 6.3%
As observed, the simple ROI and annualised ROI numbers are very different. The latter can offer better insights into an investment’s performance.
What is a ‘good’ return on investment?
ROI is a subjective metric. A good ROI solely depends on the investment vehicle. For instance, the average ROI in the stock market is 10% annually. By using the above-mentioned ROI formula, you can identify the % growth of your portfolio in the past year. Or, you can connect your portfolio on Tickertape and get real-time updates on ROI.
If your portfolio has outperformed and grown more than 10% per annum, you have a good ROI on your investment.
What are the advantages of ROI?
- ROI is simple to calculate and helps analyse the performance of an investment or a business.
- ROI can aid the comparison of returns from different investments.
- ROI can help make better financial decisions.
What are the disadvantages of ROI?
- Simple ROI does not consider the time period the investment is held.
- ROI doesn’t consider age or risk tolerance, the two most crucial aspects when formulating an investing strategy.
- ROI calculation may miss out on considering the actual cost, depending on the formula (like transaction costs, taxes, and fees).
- ROI calculations differ between all investors and businesses, making the comparison between investments imprecise.
What are the alternatives to ROI?
In reality, an ROI may provide only limited information. Thus, you might want to consider other ROI alternatives.
- Social ROI (SROI)
SROI is a systematic method of incorporating economic, social, and environmental values into decision-making processes. Depending on the economic value of environmental and social outcomes, one can gauge whether a business, enterprise, or development project is beneficial and profitable.
The formula is –
SROI = Net present value of benefits / Net present value of the investment
- Marketing Statistics ROI
Marketing ROI justifies how marketing campaigns and programs from different channels have performed and generated revenue for the business. These channels include social media marketing, digital marketing, and email marketing.
The calculation is as follows –
Marketing ROI = Sales growth – Marketing cost / Marketing cost
- Social Media Statistics ROI
Social media ROI signifies the value created by your investments in social media. It also proves whether or not your social media marketing strategies are effective and generating the intended results. One of the ways to calculate the time, money, and resources invested in social media is –
Social media ROI = Value / Total Investment X 100
Conclusion
Return on investment (ROI) is a common financial metric that measures returns from investments and businesses. While ROI percentage is essential and crucial, it’s also important to be aware of its limitations. Remember, ROI cannot be the only metric to make your decisions; however, it can be a good place to start evaluating an investment.
