Return on Investment is a performance measure that is used to evaluate how efficient an investment is, or for efficiency comparisons of numerous investments. ROI measures how much return you will receive on an investment relative to the cost of the investment. To work out return on investment as a percentage or ratio, you divide the return or benefit of an investment by the cost of the investment.
The formula is as follows:ROI = (Gain from Investment- Cost of Investment) / Cost of investment
In this ROI formula, ‘Gain from investment’ means the proceeds that have been obtained from selling the investment in question. Because ROI is expressed as a percentage, it allows for easy comparison against returns from other investments, which means you can measure a range of types of investments against each other.
ROI is a very commonly used metric as it’s very simple and versatile. Ultimately, it can be used as a gauge for working out how profitable an investment will be. It’s generally quite easy to calculate and interpret, and also applies to a wide range of investment types. Therefore, if the ROI on an investment is not positive, or if an investor finds another opportunity with a higher ROI, then these values can give him or her an idea as to which investment they should go for.
The downside of ROI models is that they don’t factor in the likelihood of those costs and returns matching predictions. As well as this, ROI models that provide only a financial measure fail to outline the intangible aspects of a certain opportunity. If not properly understood, there is also the risk of specific ROI models being misunderstood, and may in some cases encourage investors to favor opportunities that are less attractive. E.g. An investor that relies only on the internal rate of return model would end up favouring a $1 investment that in the first year would generate $2 over a $5,000 investment that over that period would generate $8,000.
How you calculate a return on investment can be adapted to suit the situation. Costs and returns may vary. Broadly speaking, the definition of the term aims to measure how profitable an investment will be, and therefore there is no one correct calculation.
For example, a marketing manager is able to compare two different products by taking the gross profit that each product has generated and dividing it by its associated marketing expenses. However a financial analyst could compare the same 2 products but use a totally different ROI calculation. He could instead divide the net income of an investment by the total value of all of the resources that have been used to manufacture and sell the product. When ROI is being used to evaluate real estate investments, one could use the property price as the ‘Cost of Investment’ and the final sale price as the ‘Gain from Investment’ although this method fails to take into account all of the intermediary costs, like property taxes, renovations, and real estate agent fees.
How flexible this tends to be then reveals another drawback of using ROI, as ROI calculations risk being easily manipulated to suit the purpose of the user, and the results can be expressed in various ways. Therefore, when using the ROI metric, a savvy investor would ensure that he or she well understands what inputs are being used. An ROI investment ratio on its own can express a picture that actually is quite different from an accurate ROI calculation; one that has incorporated each relevant expense that has gone into the development and maintenance of an investment over that period of time, and so investors should always ensure that they take into consideration the bigger picture.
Certain businesses and investors have recently become intrigued by the development of a new type of ROI metric called ‘Social Return on Investment.’ SROI was first developed just after 2000 and takes into consideration social impacts of projects. It also aims to include those that have been affected by decisions that have been made in the planning of capital and resource allocation.
by CFO.University
by Benjamin J. Boyle
by Big4WallStreet
by CFO.University
by Oksana Babenka
