Table of Contents
What is ROI?
How to calculate ROI
Return on investment vs. rate of return (ROR)
Return on investment vs. return on equity (ROE)
Limitations of return on investment
Using ROI along with IRR and NPV
The bottom line
Oct 17, 2022
9 min read
Return on investment is a useful basic measure of the profitability of an investment or business project. But it has limitations that investors use to have annual-equivalent returns.
At some point, every investor is bound to ask: Are my investments making money for me? Whether it’s shares of stock, a mutual fund, real estate, or anything else purchased as an investment, the investor wants to know if it’s profitable, and by how much.
Return on investment, or ROI, is a basic measure that answers the question of profitability, by examining the cost of the investment, its current or market value, and any gain or loss on the investment. It is expressed as a percentage rate.
Return on investment is used mostly by small investors to gauge the historical performance of stocks or funds. It simply tracks the investment’s performance from start to finish.
Because of ROI’s simplicity, investors as well as business managers can make a quick cost-benefit analysis of particular investments, sorting and comparing them by higher returns, lower returns, zero returns, or losses.
Return on investment can be used to assess a variety of investments including stocks, business projects, real estate—even home renovations. It is most frequently used by investors to keep score on stocks and funds, but it also helps companies analyze whether expansions, acquisitions, or new ventures were prudent decisions.
Calculating return on investment is very simple, which is why it’s so frequently used. The basic return on investment formula, expressed as a percentage, is:
(Current value of investment - Cost of investment) / Cost of investment = ROI
Multiplying the decimal result by 100 converts the figure into a percentage.
There are a number of ways the calculation can be used. Here’s a hypothetical example of a return on investment for a stock:
An investor buys 100 shares of XYZ Corp. for $50 each, or $5,000. Six months later, the investor sells the shares for $55, or $5,500, a gain of $500. The return on investment:
$5,500 - $5000 / $5,000 x 100 = 10%
A hypothetical example of a business project’s return on investment might look like this:
For example, Quicksale Inc., decided five years ago to invest $1 million in new software to improve tracking and delivery of customer orders. It attributed $1,750,000 in additional sales over the ensuing years from the improved software. Its return on investment is:
$1,750,000 - $1,000,000 / $1,000,000 = 0.75 or 75%
Return on investment is useful to investors and business managers because percentages can be compared across all types of investments and business projects, regardless of the scale of dollar amounts.
For example, a $1,000 investment in shares of ABC Corp., which an investor later sold for $1,200, a $200 gain, might seem less significant compared with a homeowner’s $100,000 profit on a home bought for $600,000 and sold for $700,000.
But on a percentage basis, ABC investor’s return on investment is a more impressive 20%:
$1,200 - 1,000 / $1,000 = 0.20 or 20%
The homeowner’s return on investment by comparison is:
$700,000 - $600,000 / $600,000 = 0.1667 or 16.67%
To get a true apples-to-apples comparison of investment returns, they must be annualized, or converted to an annual equivalent rate. This is called the rate of return. For investors, companies, and financial markets, a normal business cycle is one year, so returns must be compared based on the assumption of a year’s performance.
In other words, a 10% return on a stock investment in six months is different from a 10% return in two years.
Rate of return is based on the principle of the time value of money, which among other things means a dollar in the present is worth more than a dollar in the future. Time value of money is expressed through compound returns. This means simply that returns grow exponentially, not arithmetically.
So for example, with the two 10% returns above, the six-month return isn’t simply doubled to 20% for an annualized rate; the 10% is squared, to 21%. Conversely, the 10% return across two years must be reduced to an annual equivalent, using the square root of 10%, which is 4.88%.
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Return on investment is the ratio of profit or gain divided by the cost of the investment, regardless of the source of the funding. It includes all sources of money used for investment—the investor’s own money (equity) or borrowed money (leverage). ROI is a measure of overall profitability of an investment or business project.
Return on equity, or ROE, on the other hand, is the ratio of profit divided only by the investor’s own invested money, or equity, minus any borrowed money, or leverage. It is a measure of how efficient the investor’s equity is being used to generate a profit.
Using leverage can produce a higher return on equity. Here’s a hypothetical example: An investor spends $10,000 to buy shares of Widget Co. A year later, the investor sells the shares for $12,000, a gain of $2,000, or a 20% ROI based on:
$12,000 - $10,000 / $10,000 = 0.20 or 20%
Return on investment and return on equity are the same in this case, assuming the $10,000 used to buy the shares was entirely the investor’s own money.
Now let's say that half the $10,000 investment was the investor’s money (equity) and half was borrowed money (leverage). The investor agrees to pay interest at an annual 7% rate on the $5,000 borrowed, or $350. So after one year, the investor’s net gain is $1,650 after subtracting the interest expense.
But in the ROE calculation, the net gain is divided by only $5,000—the investor’s equity, excluding the borrowed money. The ROE formula in this case is:
($12,000 - $10,000) - $350 / $5,000 = 0.33 or 33%
The flip side of leverage for return on equity—and the potential danger—is that losses can be magnified. For comparable investments, negative ROEs will be worse than negative ROIs if funds are borrowed for a losing investment.
While ROI is valued for its simplicity and ease of use across an array of investment types, return on investment has some potential limitations:
Return on investment and return on equity are types of backward-looking measures, quantifying past performance.
Internal rate of return, or IRR, is forward-looking, and involves a more complex calculation of net present values (NPV) of expected future cash flows—money the investment is expected to generate. Various online calculators are available that can produce IRR and NPV results, which typically involve varying amounts of expected cash flows at different times in the future, and the exponential discounting of those cash flows to present values.
Analysts and business executives often perform IRR calculations to assess the feasibility of investment plans or business projects by calculating estimated returns. The IRR calculation is weighed against some minimum required return for a company to consider proceeding with the investment or project. For example, if a company’s cost of capital such as borrowing is 7%, it would need an internal rate of return higher than 7% to justify the investment.
Companies typically use IRR when considering expansion, an acquisition of another company, or even a stock buyback.
Return on investment (ROI) is a useful basic measure of the profitability of an investment or business project, and can be used for broad comparisons among many types of investments. But ROI has limitations and investors tend to use it along with other measures that convert returns to an annual-equivalent rate for insight into how various investments stack up. Other calculations account for any income from the investment, to produce a total return.
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