What Does ROI Mean?
ROI (or return on investment) measures the gain/loss generated by an investment in relation to its initial cost. ROI allows the reader to gauge the efficiency and profitability of an investment and is often used to influence financial decisions, compare a company’s profitability, and analyze investments.
How to Calculate ROI
Return on investment is a key financial ratio that measures the gain from an investment relative to the amount invested. You can calculate ROI by dividing net profit (current value of investment - cost of investment) by the cost of investment.
What Is the ROI Formula?
The simplest ROI equation is as follows:
For the most straightforward way to tabulate ROI, there are plenty of online return on investment calculators available.
How Can ROI Be Used?
There are many scenarios where ROI is useful:
ROI Example #1
An investor buys $1,000 worth of stocks and sells them 1 year later when their value reaches $1,500.
In this case, the net profit of the investment ( current value - cost ) would be $500 ($1,500 - $1,000), and the return on investment would be:
ROI Example #2
A company spends $5,000 on a marketing campaign and discovers that it increased revenue by $10,000.
In this case, the return on investment would be:
ROI Example #3
A homeowner is considering a home renovation to add an extension and pool. The home is currently appraised at $500,000 and the renovations will cost $100,000 – but they're also expected to increase the value of the home by $250,000. In this case, the return on investment would be:
Return on Investment Interpretation
Due to its flexibility and simplicity, ROI is one of the most frequently used profitability metrics. It's extremely useful for measuring the efficiency and success of investments and helps investors, analysts, and companies make future business decisions.
With a key performance indicator, users can determine whether an investment is worth making – and then track its performance.
Pros and Cons of Using Return on Investment
Like any other profitability metric, there are advantages and disadvantages of using ROI. Consider the following benefits and drawbacks:
Pros of using Return on Investment
Simple. The ROI formula only requires a few inputs and provides a single output value, making it a very straightforward way to track efficiency and profitability.
Clear. A positive number indicates a positive return, whereas a negative number indicates a loss.
Flexible. ROI works for a variety of investments such as marketing campaigns, stock purchases, vehicles, home renovations, and beyond.
Versatile. ROI can be used for a number of applications like tracking efficiency, measuring profitability, analyzing business decisions, and more.
Divisional. Since ROI measures the return of a single investment, companies can track the profitability of each business unit to optimize their operation and increase earnings.
Cons of Using Return on Investment
Room for error. One of the most common ROI mistakes is confusing cash flow and profit, resulting in a much higher expected return. Additionally, to calculate a useful ROI, you need to first determine your baseline in order to calculate any incremental profit.
Variance. The standard formula for ROI is profit/cost, but the definition of those inputs can vary, depending on a company’s accounting policies. Factors like interest, tax, and net profit vs. gross profit can influence the outcome, making it hard to accurately compare companies.
Potential bias. ROI is a great indicator of profit, but it doesn’t always consider the full picture. Investments that have a lower ROI (but improve the business as a whole) could be disregarded if the company only focuses on increasing their ROI.
Manipulation. Business unit managers can manipulate ROI by changing accounting policies & calculations, reducing spending on inputs, or even discarding old yet functional equipment. This practice can decrease cost or increase return to give the illusion of strong performance even if the actions are detrimental to the company as a whole.
Disregards time. A 10% gain over one year is better than a 10% gain over two years, but when measuring the profitability of an investment, ROI doesn’t consider the holding period. This can lead to investors or managers avoiding new investments due to the uncertainty of returns or prioritizing short-term gain over long-term profitability.