Return on Investment (ROI): meaning and how to Calculate

Return On Investment (ROI) is a measure of profitability used to compare the effectiveness of different investments.

Generally, ROI is calculated by taking the benefit or return of an investment and dividing it by its cost. The return on investment has the function of directly calculating the remuneration of a particular project in relation to the required cost.

return on investment formula

ROI is expressed as a percentage or ratio. It is popular due to its versatility and simplicity and can be modified for different situations. Depending on the context, ROI will take on one meaning or another:

  • In the case of a company, it can be a way to measure the efficiency of management, benefits, savings in costs or the ability of the company to obtain profits using its assets. Thus, in this context, ROI is the same as ROA (return on assets) and would be calculated as the division of the net profit after taxes by the total assets. .
how to calculate return on investment
  • ROI can also be used to justify a project, based on the estimated benefits of the project and its expected costs.
  • Sometimes, it is used to measure the return of the efforts made to increase the market share, enter new markets or develop some kind of infrastructure. In these cases, ROI would be used to measure the efficiency in achieving the objectives.

Comparing ROI of different projects

Comparing the ROI of different projects, YOU can determine which of them should be undertaken. The rule is simple: If an investment does not have a positive ROI or other investments have a higher ROI, that investment should not be carried out.

Also, the duration of the expected ROI is also a determining factor of the strength of an ROI. For example, investment X have an ROI of 60% over the next five years and Investment Y have a possible ROI of 45% over the next three years. By calculation, you will find that X will yield 8.15% of your investment over the next five year and investment Y will yield 8.61% of the original investment over three years.

It should be noted that, if you are not cautious, the ROI can be manipulated to fit the needs of the user or the project manager. This is possible, because there may be some costs that are not clear whether they should or should not be included when calculating the benefit of the investment.

How to Calculate Return on Investment

This can be calculated using 2 different methods.

First Method:

how to calculate roi

Second Method:

roi formula

To understand these calculations, the following should be taken into account:

  • ROI is expressed as a percentage because it is intuitively easier to understand.
  • The calculation of ROI includes a net yield in the numerator that can be positive or negative. When ROI calculations yield a positive figure, it means that net yields are in the black (total returns exceed total costs).
  • When ROI calculations yield a negative figure, it means that net yields are in the red because total costs exceed total returns. (That is, this investment results in a loss).
  • To calculate ROI more accurately, total returns and total costs must be taken into account.

Return on Investment: Digital Marketing Example

One of the most common uses of this indicator is in digital marketing. The principle is the same, divide the return by the investment made.

For example, imagine the average income for each user of our website who became a customer is 80 euros, and that the page obtained 120 customers during the month. Also, the cost of maintaining the page is 6,800 euros per month. First, we can calculate the return: (80*120)-6,800 = 9,600-6,800 = 2,800. Then, we divide by the required cost: 2,800/6,800=0.4118=41.18% The result tells us that for every euro invested, 0.4118 euros of profit were obtained.

How to use ROI

Regular investors use ROI to evaluate their stock investment portfolio, applying all expenditures and cost on the investment.

A business owner can use ROI to calculate his return or potential return on cost of advertising his business, bearing in mind the cost of the advert and the potential sale attached to the advertisement if it is worth investing.

It is important to know that ROI only produce results according to the number you feed it, and it cannot rule out the chance of loss or uncertainty. Therefore, when you are calculating your potential ROI it is important you factor in other factors and risk of investment. Other financial ratios, might help you out, mitigate the risk of taking a rash decision, based just on this.

What is a good Return on Investment (ROI)?

The value that qualifies as a good ROI depends on several factors such as risk tolerance of the investor and the duration required for the investment to generate the return.

Generally, investors who care careful of the level of risk they take will likely accept a lower ROI in exchange for staying safe on their investment, and investors who take large risk may likely make large ROI on their investment.

However, conventional wisdom consider an ROI of approximately 7% or greater annually as a good return for an investment in stock. This is also about the average annual return of the S&P 500, accounting for inflation

Conclusions

In conclusion, Return on Investment can be used by regular investors who need it to evaluate their portfolios, or it can be applied to analyse almost any type of expenditure. ROI is an understandable and easy to calculate metric, which can be complemented with other fundamental analysis ratios, to determine the efficiency of a project. For that reason, it is popular to compare options of where to place capital. Now, a good ROI will depend on factors such as the investor's risk tolerance and the time required for the investment to generate a return.

In this case, investors who are more risk-averse will likely accept lower ROIs in exchange for taking on less risk and, likewise, investments that take longer to pay off generally require a higher ROI to be attractive to investors. Another point that we cannot overlook is that ROI has limitations, for example, it does not consider the time of the investment or seasonality. This last one means that, although in the medium or long term the return is positive, the result can be negative in shorter periods, for example, in a given quarter.

FAQs about Return on Investment (ROI)

What is ROI?

Return on Investment (ROI) is a straightforward measurement of how much profit (or loss) did an investment make after considering it cost over a period. It also aids decision-making process of a new investment.

Is ROI a Percentage?

It provides a ratio of the amount gained to the cost of the investment and the ratio can be expressed as percentage to make it easy for comprehension. It is simply the ratio of profit margin

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