What Is the Meaning of ROI?
ROI (or Return On Investment) measures the gain or loss generated by an investment in relation to its initial cost. It 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 simple ratio of 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?
ROI Calculation Example
There are many scenarios where ROI can be useful:
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:
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:
A homeowner is considering renovating their home to add an extension and pool. The home is currently appraised at $500,000 and the renovations will cost $100,000, but are expected to increase the value of the home by $250,000. In this case, the return on investment would be:
Why Is ROI so Important?
ROI is one of the most frequently used profitability metrics because of its flexibility and simplicity. With this key performance indicator (KPI), the user can determine whether an investment is worth making and then track its performance. It's extremely useful for measuring the efficiency and success of investments and helps investors, analysts, and companies make future business decisions.
Pros and Cons of Using ROI
Like any other profitability metric, there are pros and cons of using ROI. Consider the following benefits and drawbacks:
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.
Room for error. Using the wrong input values can result in an inaccurate ROI. One of the most common mistakes people make when calculating ROI is confusing cash flow and profit (resulting in a much higher expected return). In addition, to calculate a useful ROI you need to first determine your baseline in order to calculate any incremental profit. In the marketing example above, this would mean trying to determine how much of the increase in sales was truly due to the marketing campaign.
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 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 uncertainty of returns or prioritizing short-term gain over long-term profitability.
Ask the Experts About ROI
InvestingAnswers is on a mission to help individuals build and protect their wealth through education. That is why we have experts answering your pertinent financial questions at the end of each article.
Q: What Is a Good ROI?
A positive ROI is not necessarily a good ROI, as the return must be compared to other investments with similar risk characteristics. In general though, the higher the ROI percentage, the greater the return on investment which indicates increased efficiency and profitability. However, ROI doesn’t always paint the full picture as investments that have a lower ROI could have other benefits (e.g. long-term growth potential), so it’s important to consider other metrics before making financial decisions.
Q: Are There Different Ways to Calculate ROI?
Absolutely. The basic ROI formula can be used in a number of situations, but there are other variations that can be used for other applications.
- Real Rate of Return (RRR). Measures the return of an investment after adjusting for inflation, taxes, and other external factors.
- Annualized ROI. Measures the return an investment generates in a single year. It’s calculated by dividing the ROI by the number of years the investment is held.
- Net Present Value (NPV). Allows the reader to calculate the present-day value of an investment based on inflation-adjusted projections of its future earnings.
- Return on Assets (ROA). Measures a company's profit for every $1 of assets it owns.
- Return on Equity (ROE). Measures how much profit a company generates for every $1 of company equity held by shareholders.
Q: Can Return on Investment Be Negative?
Yes, a return on investment can be negative. A negative ROI means the investment lost money. Essentially you would have less than the initial investment which is obviously not ideal.
Q: What Are Simple Ways to Improve My ROI?
This question depends on who you are- either a company or an investor.
For a company, there are three simple ways to improve ROI:
- Increase sales
- Reduce costs
- Raise prices
If you’re an investor, ROI or investment returns depend on what you choose to invest in and who you invest with (the company itself). If you want to maximize your investment returns, you can:
- Reduce fees by finding low-cost ways to invest
- Diversify your portfolio
- Use the tax-advantaged accounts you have access to (401k, HSA, etc)
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