Return on Investment is a measure of how much profit or money is obtained from an investment, and is expressed as a percentage. Investors calculate return on investment (ROI) to gauge the efficiency of their investment.
Investors use return on investment to establish how successful their investment is performing, and also to compare its efficiency relative to other investments. ROI will vary based on what an investor is investing in and what they consider to be “favorable returns.” But even so, an investor can’t assess the profitability of any investment, whether its rental property, bond, stock, option or collectible, without an understanding of how to calculate return on investment (ROI).
The formula for calculating ROI acts the basis from which business make informed investment decisions, and while the calculation stays constant, different kinds of investments bring along unique variations to the equation.
This article will discuss the basics of ROI along with some aspects that investors should bear in mind when using it in their investment decisions.
To calculate the ROI of an investment, one would need to take the cumulative ROI and subtract the initial cost of the investment. But since ROI is a profitability percentage or ratio, it’s represented in percentage or ratio forms. To get the percentage profit, one should take the net gain (profit) and divide it by the original cost and multiple by 100 as elaborated below.
ROI = ((Profit on investment-original cost of investment) / original cost of investment) x100
The primary goal of ROI is to represent the value or additional money that one obtains – the return or benefit they gained – as a ratio or percentage of their original investment.
As an example, a business person buys an inventory worth $200,000. After a year, they manage to sale the whole inventory for $300,000. The ROI is the final sale price (in this case $300,000) less the buying price (or $200,000). To calculate the ROI, the business person would divide his or her profits ($300,000 – $200,000 = $100,000) by the investment cost ($200,000), for a return on investment of $100,000/$200,000, or 50%.
With this data, it’s easy for the business person to compare his or her investment in inventory with their other projects. Suppose they invested $250,000 in another business and sold the products for a total of $300,000 after a month. The ROI would be ($300,000 -$250,000 = $50,000), $50,000/$200,000=25%.
Limitations of ROI
Real estate can attract returns in two ways, through price appreciation and rental income. The ROI includes price gains when the property value goes up and the rent collected. However, the investment cost arises from a range of sources, including initial purchase price, insurance, property taxes, and upkeep.
Yes, people can earn a 200% return from selling their property, but often, this amount is the difference between their initial investment on buying the property and amount they sold it for – but not inclusive of other costs. Real estate is a profitable niche; however, their estimated ROI can be exaggerated if one doesn’t include all costs.
Some collectibles, like the Mona Lisa Painting, Scrap Dealer Egg, Action Comics #1 and so on are worth hundreds of thousands of dollars, making for substantial ROI when matched to their original prices. But they are rarely bought at their initial cost and based on the type, have high maintenance and insurance cost that lower their ROI.
It’s easy for one not to factor in the costs of transactions when investing in stocks, even though this can inflate the ROI. For instance, if one made a $100 gain on a stock investment, but incurred a $10 transaction fee when he or she purchased the stock, and also when they sold it, the original ROI of $100 would be inaccurate.
ROI measures the bottom line of an investment, but it does not factor in the amount of time the investment has taken. For instance, if investment in “A” has an ROI of 50% and “B” has an ROI of 100%, from the face value, the 100% benefit takes the day. However, if it took investment “B” five years to achieve the 100%, while it took investment “A” only a month to reach the 50% gain, then investment “B” would not be as impressive.
Like in the above scenario, the business person obtained a 50% ROI after a month in one business; and a 25% ROI after a year in another business. While the 50% seems appealing at first, the amount of time, it takes to realize the return is longer much when compared to the 25% ROI after a month. As such, it is essential for business people to factor in the amount of time an investment takes when calculating the ROI.
Calculating return on investment (ROI) is an excellent way for businesses to keep track of their progress regarding profits. But even so, investors should keep in mind that it’s a historical measure – it takes record of past returns, which often don’t guarantee future results.
For instance, an investment in stock might produce an ROI of 300% to 500% in its growth stage, but drop as the company matures. If one invests in stocks after the growth stage, depending on the historical ROI, their gain won’t match the past returns. It’s also important to note that the projected return on investment on unproven investment is even more unreliable when there is no data to back it up.