What is ‘Return on Investment (ROI)’
Return on Investment (ROI) is a performance measure, used to evaluate the efficiency of an investment or compare the efficiency of a number of different investments. ROI measures the amount of return on an investment, relative to the investment’s cost. To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.
The return on investment formula:
ROI = (Gain from Investment – Cost of Investment) / Cost of Investment
In the above formula, “Gain from Investment” refers to the proceeds obtained from the sale of the investment of interest. Because ROI is measured as a percentage, it can be easily compared with returns from other investments, allowing one to measure a variety of types of investments against one another.
BREAKING DOWN ‘Return on Investment (ROI)’
ROI is a popular metric because of its versatility and simplicity. Essentially, ROI can be used as a rudimentary gauge of an investment’s profitability. The calculation is not complicated, relatively easy to interpret, and has a range of applications. If an investment’s ROI is not positive, or if other opportunities with higher ROIs are available, these signals can help investors eliminate or select the best options.
For example, suppose Joe invested $1,000 in Slice Pizza Corp. in 2010 and sold his shares for a total of $1,200 one year later. To calculate his return on his investment, he would divide his profits ($1,200 – $1,000 = $200) by the investment cost ($1,000), for a ROI of $200/$1,000, or 20%.
With this information, he could compare his investment in Slice Pizza with his other projects. Suppose Joe also invested $2,000 in Big-Sale Stores Inc. in 2011 and sold his shares for a total of $2,800 in 2014. The ROI on Joe’s holdings in Big-Sale would be $800/$2,000, or 40%. (See Limitations of ROI below for potential issues arising from contrasting time frames.)
Limitations of ROI
Examples like Joe’s (above) reveal some limitations of using ROI, particularly when comparing investments. While the ROI of Joe’s second investment was twice that of his first investment, the time between Joe’s purchase and sale was one year for his first investment and three years for his second.
Joe could adjust the ROI of his multi-year investment accordingly. Since his total ROI was 40%, to obtain his average annual ROI, he could divide 40% by 3 to yield 13.33%. With this adjustment, it appears that although Joe’s second investment earned him more profit, his first investment was actually the more efficient choice.
ROI can be used in conjunction with Rate of Return, which takes in account a project’s time frame. One may also use Net Present Value (NPV), which accounts for differences in the value of money over time, due to inflation. The application of NPV when calculating rate of return is often called the Real Rate of Return.
[Note: There are a range of metrics used to evaluate a company’s financials and to determine if it is a sound investment. Investopedia Academy’s Fundamental Analysis course walks you through this process and leaves you equipped to decide if a certain stock is will make a smart addition to your portfolio. Learn more today!]
Developments in ROI
Recently, certain investors and businesses have taken an interest in the development of a new form of the ROI metric, called “Social Return on Investment,” or SROI. SROI was initially developed in the early 2000s and takes into account broader impacts of projects using extra-financial value (i.e. social and environmental metrics not currently reflected in conventional financial accounts).
For a more in-depth look at ROI, see “FYI on ROI: A Guide to Calculating Return on Investment.”