ROI

When someone says something has a good or bad ROI it’s important to ask them to clarify exactly how they measure it.

Return on Investment (ROI) is a performance measure, used to evaluate the efficiency of an investment or compare the efficiency of a number of different investments.To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.

The return on investment formula:

ROI = (Gain from Investment - Cost of Investment) / Cost of Investment

ROI Formula

Return on investment (ROI) is a financial ratio used to calculate the benefit an investor will receive in relation to their investment cost, most commonly measured as net income divided by the original cost of the investment. The higher the ratio, the greater the benefit earned. This guide will break down the ROI formula.

There are several versions of the ROI formula. The two most commonly used are shown below:

ROI = Net Income / Cost of Investment

or

ROI = Investment Gain / Investment Base

Example of ROI calculation

An investor purchases property A, which is valued at $500,000; two years later, the investor sells the property for $1,000,000.

We use the investment gain formula in this case.

ROI = (1,000,000 – 500,000) / (500,000) = 1 or 100%

or

ROI = Return(Benefit) / Investment (Cost)

Benefits of ROI

1. Simple and Easy to Calculate

The return on investment metric is frequently used because it’s so easy to calculate.  Only two figures are required – the benefit and the cost.  Because a “return” can mean different things to different people it makes the formula easy to use as there is not a strict definition of “return”.

2. Universally Understood

Return on investment is a universally understood concept and so it’s almost guaranteed that if you use the metric in conversation people will know what you’re talking about.

Limitations of ROI - Disregards the Factor of Time

A higher ROI number does not always mean a better investment option. For example, two investments have the same ROI of 50%; the first investment is completed in three years, while the second investment needs five years to produce the same yield. The same ROI for both investments blurred the bigger picture, but when the factor of time was added, an investor can easily see the better option.

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