ROI is a way to measure an investment's performance. As you'd expect, it's also a great way to compare the profitability of different investments. Naturally, an investment with a higher ROI is better than an investment with a lower (or negative) ROI.
But how do you measure the performance of your investments? And how can you compare the performance of multiple investments? This is where the ROI calculation comes in handy. In this article, we'll discuss how to calculate return on investment (ROI).
What is Return on Investment with Example
Return on investment (ROI) is a way to measure an investment's performance that can also be used to compare different investments. It measures the gains or losses compared to the initial investment; in other words, it's an approximation of an investment's profitability. Compared to the original investment, a positive ROI means profits, and a negative ROI means losses.
ROI calculation applies to not just trading or investment, but any kind of business or purchase. Calculating an estimated ROI based on all your projected expenses and returns may help you make a better business decision. If it seems like the business would turn a profit in the end (i.e., have a positive ROI), it may be worth getting it started.
Also, ROI can help evaluate the results of transactions that already happened. For example, let's say you buy an old exotic car for $200,000. You then use it for two years and spend $50,000 on it. Now suppose that the car's price goes up on the market and you can now sell it for $300,000. Not only did you enjoy this car for two years, but it also brought you a sizable return on your investment. How much would that be exactly? Let's find out.
How to Calculate Return on Investment (ROI)
The ROI formula is quite simple. You take the current value of the investment and subtract the original investment cost. Then, you divide this sum by the original cost of the investment.
ROI = (current value - original cost) / original cost
ROI = (300,000 - 200,000) / 200,000 = 0.5
Your ROI is 0.5. If you multiply it by 100, you get the rate of return (ROR).
0.5 x 100 = 50
This means that you made a 50% gain on your original investment. However, you need to take into account how much was spent on the car to get the full picture. So, let's subtract that from the current value of the car:
300,000 - 50,000 = 250,000
Now, you can calculate ROI while taking into account the expenses:
ROI = (250,000 - 200,000) / 200,000 = 0.25
Your ROI is 0.25 (or 25%). This means that if we multiply your cost of investment ($200,000) by your ROI (0.25), we can find the net profit, which is $50,000.
200,000 x 0.25 = 50,000
Limitations of Return on Investment
ROI is very easy to understand and brings a universal measure of profitability but surely there are some limitations. One of the biggest limitations of ROI is that it doesn't take into account the time period as time is a crucial factor for investments. There could be other considerations (like liquidity and security), but if an investment brings 0.5 ROI in a year, that's better than 0.5 ROI in five years. This is why you may see some talking about annualized ROI, which represents the investment returns (gains) you could expect over the course of a year.
Another factor to consider is risk. An investment might have a very high prospective ROI, but at what cost? If there's a high chance that it goes to zero, or that your funds become inaccessible, then the prospective ROI isn't all that important. The potential reward could also be high, but losing the entire original investment is certainly not what you want.
Additionally, purely looking at ROI won't give you insights into its safety, so you should consider other metrics as well. You could start by calculating the risk/reward ratio for each trade and investment. This way, you can get a better picture of the quality of each bet. In addition, some stock market analysts may also consider other factors when evaluating potential investments. These can include cash flows, interest rates, capital gains tax, return on equity (ROE), and more.
Closing Thoughts
We've looked at what is return on investment with example and how to calculate return on investment. The return on investment formula is a core part of tracking the performance of any portfolio, investment, or business.
And as we've discussed, ROI can be useful but isn't and shouldn’t be the ultimate metric. You also need to consider opportunity cost, risk/reward ratio, and other factors that may have an impact on your choice between different investment opportunities. As a starting point, however, ROI can be a good barometer to evaluate a potential investment.
