RETURN ON INVESTMENT FORMULA
What Is The Definition of Return on Investment (ROI)?
Return on investment (ROI) is a financial ratio that calculates the benefit an investor receives in relation to the cost of their investment. It is most commonly calculated as net income divided by the investment’s original capital cost. The greater the ratio, the greater the benefit. This guide will explain the ROI formula, provide examples of how to calculate it, and provide a ROI formula investment calculator for download.
Return on Investment Formula
The ROI formula is available in several variations. The two most popularly used are illustrated below:
ROI = Net Income / Cost of Investment
or
ROI = Investment Gain / Investment Base
The first version of the ROI formula (net income divided by investment cost) is the most commonly used ratio.
The ROI formula is easiest to understand by taking some type of “benefit” and dividing it by the “cost.” When someone says something has a good or bad ROI, it’s important to ask how they measure it.
Calculation of the Return On Investment Formula Example
An investor buys property A, which is worth $500,000. The investor sells the property for $1,000,000 two years later.
In this case, we employ the investment gain formula.
ROI = (1,000,000–500,000)/(500,000) = 1 or 100%.
The Calculation of the Return On Invest Formula
ROI calculations are straightforward and can assist an investor in deciding whether to pursue or pass on an investment opportunity. The calculation can also be used to determine how well an investment has performed thus far. When an investment generates a positive or negative ROI, it can provide important information to the investor about the worth of their investment.
Using a ROI formula, an investor can distinguish between low-performing and high-performing investments. Besides, investors and portfolio managers can use this approach to try to optimize their investments.
The ROI Formula’s Advantages
Every analyst should be aware of the numerous advantages of using the return on investment ratio.
1. Easy to calculate and simple
Because it is so simple to calculate, the return on investment metric is frequently used. There are only two figures required: the benefit and the cost. Because “return” can mean different things to different people, the ROI formula is simple to apply because there is no strict definition of “return.”
2. Universally Understood
Return on investment is a universally popular concept. Therefore, it’s almost guaranteed that if you use the metric in conversation, then people will know what you’re talking about.
The ROI Formula’s Limitations
While the ratio is frequently useful, there are some limitations to the ROI formula that should be understood. Two important points are below.
The ROI Formula Ignores the Time Factor
A higher ROI does not always imply a better investment. For instance, two investments have the same ROI of 50%. The first investment, however, is completed in three years, whereas the second investment requires five years to produce the same yield. The same ROI for both investments muddled the bigger picture, but when time is factored in, the investor clearly sees the better option.
The investor must compare two instruments over the same time period and under the same conditions.
Manipulation Possibilities for the ROI Formula
An ROI calculation will differ between two people depending on which ROI formula is used. A marketing manager can use the example property calculation without accounting for additional costs such as maintenance, property taxes, sales fees, stamp duties, and legal fees.
An investor must consider the true ROI, which takes into account all potential costs incurred when each investment increases in value.
