Return On Investment: an introduction
One of the most important and commonly referred to measures of profitability in a business or from an investment is the return on investment. Often referred to as simply ROI, this calculation indicates the amount that is gained or lost from a particular investment or item of expenditure relative to the cost.
The ROI is a helpful indication of whether a particular investment was worth it or not and can be a helpful predictive evaluation of whether to make a particular investment or not in the future.
There are a few other measurements that are used in addition to ROI by business analysts.
1. Internal Rate of Return (IRR); and
2. Net Present Value (NPR)
Uniquely, despite ROI actually being a ratio (in the form of profit/loss:cost) it is most commonly expressed in the form of a percentage.
Understanding ROI
The key to understanding what the return on investment of a particular project or investment means, it’s important to understand that it is only an approximate measure of profitability. Its limitation is that it does not account for how long a particular investment is held, for example.
Therefore, it is possible that an investment held for the short term with a lower ROI can be a more effective financial strategy than an investment with a higher ROI but was only realised over a longer term.
When one calculates the return on investment you start with the final value of the project or investment. You then subtract the initial cost and divide that result by the cost of the investment as well. The answer you are left with, multiplied by 100 to be expressed as a percentage, leaves you with your return on investment.
Advantages of ROI
1. The return on investment formula is easy to calculate.
Unlike some other metrics of investments and business projects, the ROI is very easy to calculate and not at all difficult to understand conceptually.
2. Universally accepted
ROI is considered to be a universal standard of measuring profitability. Thanks to its simplicity in calculation and straightforwardness as a measure, it can be used to compare vastly different investments in highly varied contexts.
Disadvantages of ROI
1. Investment holding period is not measured.
The most obvious disadvantage of using a ROI, which we did mention briefly before, is that the calculation does not take into account the holding period of the investment or project.
There is no way to know within the return on investment formula whether the return was generated over one year, five years or 20 years. This disadvantage is addressed through the annualised ROI formula below.
2. ROI does not adjust for risk.
Investment returns are correlated with risk. In other words, the potential for higher returns is directly correlated with higher risks.
The ROI formula does not take into account risk and does not adjust accordingly. While this doesn’t affect the use of this calculation when measuring the performance or return on an investment previously placed, it can mean that ultimate outcomes of a future investment differ greatly from the predicted ROI.
3. Additional gains are not included
The return on investment formula only takes into account quantifiable financial gains. While this might be sufficient for many of its uses, if you’re looking to include the social, environmental or personal costs/benefits it may need to be supplemented through other measures and indicators.
Using ROI
There are a few aspects of the return on investment calculation that are important to understand.
- Ratio vs percentage
While ROI is presented as a percentage to be more easily digestible, it is actually a ratio and should be considered as such when making investment decisions.
- ROIs can be positive or negative
While seemingly obvious, it’s important to note that the ROI includes the net return in its calculation and thus the result can indicate a profit OR a loss on the investment.
- ROI is a simple calculation
Despite being commonly used and a helpful standard measurement, the ROI might not be sufficient for comprehensive financial decision making on its own. Its simplicity in this regard is both an advantage and disadvantage.
How to Calculate Return on Investment (ROI)
The Return on Investment Formula
There are two standard methods for working out the return on investment.
Method #1
ROI = ( The net return of the investment / the cost of the investment ) x 100
Method #2
ROI = ( (The final value of the investment – the initial value of the investment) / the cost of the investment ) x 100
Calculating the Right Costs
Getting the return on investment formula correct is critical for determining an accurate measurement. One of the most common factors that people fail to correctly determine is the cost of the investment.
Certain investments have additional costs, taxes, maintenance, insurance fees or interest that if overlooked can lead to the ROI being inflated as the full cost has not been taken into account.
Annualised Gains
The annualised gain of an investment is the average gain or return on the investment over the time period of a year.
This can be an important factor when tossing up between two different investments as a return of 10% over 10 years is going to be less attractive that 5% over 2 years even though the ROI on the former term is technically higher.
Note: The term “holding period” refers to the length of time that the investment is held before the gains are realised.
Annualised Return on Investment
The annualised ROI formula is a way to calculate the return on investment whilst taking into account the annualised gains.
While more complicated, it helps to counter the shortfall of the simplicity of the standard ROI calculation.
The annualised return on investment formula (which includes the simple ROI calculation within it) is as follows:
Annualised ROI=[(1+ROI)1/number of years the investment is held-1] x 100
Considering that the length of time an investment takes to realise a return/gain is important, it is very necessary to use both the standard ROI and annualised formula when comparing different investment options.
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Despite the inherent limitations of an ROI calculation, this important measurement is useful and informative.
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