Return on Investment (ROI)

Return on Investment (ROI) is a widely used metric in business and marketing, but many are unfamiliar with what it is and how it works. ROI is a way to calculate how much money you made or lost on an investment compared to how much money you initially invested.

This article will give an overview of what ROI is in fairly simple terms. We will also provide guidance for the different approaches used to calculate it. Whether you are just learning about ROI, or lookin g for ways to calculate it, this article is for you!

What Is Return on Investment (ROI)?

Return on Investment (ROI) is an essential performance metric, commonly used in investment analysis, especially in marketing or consultancy.

ROI allows us to evaluate the efficiency of an investment. We can also use it as a comparative metric to measure various investments’ efficiency to understand which one performs the best.

ROI quantifies the amount of return on a particular investment, compared to the investment’s cost. To calculate ROI, we need to simply divide an investment’s return by its adequate cost. A common practice is to present it as a percentage, and less commonly as a ratio.

How to Define Return on Investment (ROI)?

Return on investment (ROI) is defined as a measure of investment performance that assesses the profitability of an investment relative to its cost. It is calculated by dividing the gain or loss of an investment by its original cost.

ROI is a key metric used in business analysis to assess the efficiency of an investment and compare the performance of different investments or over different time periods. It’s also used by investors and companies to set investment goals, allocate resources, and make informed decisions. 

Overall, ROI is an important tool for investors and companies to track their investments and make informed decisions.

Why Is Return on Investment (ROI) Important?

To understand why ROI is such an important metric, let’s take a look at the three main advantages it provides to businesses.

1. Wide range of use cases

As a result of the flexibility of this calculation, it can be adjusted for different uses. Since there is no hard-set definition of what the term return actually implies, you or the investing company can understand it in a manner that fits your business.

2. Simple and easy to calculate

People often use the return on investment metric since it’s straightforward to quantify. There are only two figures you need to clarify upfront: the return and the cost. Return can mean different things to different people, therefore it is simple to use the formula since there is no clear “return” concept.

3. Globally understood

A good thing to mention is that often entrepreneurs or investors know what you are referring to if you use this specific formula or just say ROI. This is due to its very adaptable concept, ‘easy to digest’ for everyone.

Disadvantages of Return on Investment (ROI)

Although it is a widely used metric, ROI still has some disadvantages that ought to be mentioned.

1. The factor of time neglection

A higher ROI number does not necessarily indicate a better choice for investment.

Two stocks, for instance, have the same 30% ROI. However, the first investment returns an income in two years, while the second investment to achieve the exact yield, takes five years. 

Even though both investments generate the same return, the first investment is a better choice since it will generate the same return in a shorter period. However, the investor can see the better choice only when the time factor is applied.

2. Easily manipulated

An ROI estimation done by two people can differ depending on the calculation method used and what information is reflected. This is because, due to its simplicity, ROI has a very vast range of usage. 

Both parameters, return, and investment, do not have a strict definition but can be defined due to the business’s needs. For example, a person may calculate ROI but don’t consider some additional costs that may appear in between – maintenance cost, property tax, sales fees, etc.

What Is a Good ROI?

Defining a “good” ROI strongly relies on the risk that the investor is willing to take and the time needed for a return to be produced by the investment. Consequently, the investors who usually take lower risks will be satisfied with lower ROIs if all else is equal. 

Similarly, to be appealing to buyers, assets that take longer to pay off would usually require a higher return on their investment. In contrast, those who take less time for a return can allow themselves a lower ROI.

A “good” ROI also depends on the industry in which your business is operating. If you are an individual investor, generally, a 15% return will be good news for you. 

However, if your business offers digital marketing services to other businesses, you should expect at least 7 times higher returns on your investments. Therefore, there is a place for drastic differences when it comes to different industries. 

Before calculating your performance, you should check the most recent, average ROI in your industry and use it as a benchmark.

What Are the Best Strategies to Calculate ROI?

The application range of ROI is extensive. We can use ROI to calculate the total return on an investment, the capital growth when buying a stock, or calculate a total return but normalized on an annual basis. You can manipulate the formula based on your needs as long as you respect its concept – calculating return on your investment.

Net Profit calculation

Net profit is the result of subtracting the initial investment cost from the current value of the investment including returns.

ROI = (Net Profit/ Investment Cost) x 100%

Let’s look at an example. Your company is running a 10,000$ worth marketing campaign for a month already. That month, your company reached a sales growth of 15,000$. The calculation of the return on your marketing investment will be

((15,000$-10,000$)/10,000$) x 100 = 50%

Congratulations, your company has profited 5,000$ on its investment of 10,000$. Or simply said, you had a 50% return on your investment. This is your business ROI by using the Net Profit calculation.

Capital Growth calculation

This calculation applies to situations where we have something in possession on which we can achieve capital growth. This can be such assets as stocks, bonds, or any other securities. We can earn capital growth by buying them at a specific price and selling them at a higher price.

ROI=((Current Price/Original First Price)-1) x 100

Let’s imagine you are an investor. You have invested in stock worth 1,000$. After a while, you have sold the same stock for 1,200$. That means:

((1,200$/1,000$)-1) x 100 = 20%

You have a 200$ return on your 1,000$ investment. More specifically, a 20% ROI.

Total Return calculation

For this type of ROI metric, we can easily follow up on the example explained above. What if during the time we had the stock, we earned some additional dividends? That is an extra income that we should take into account since it increases our capital growth.

So, as an additional income, while having the stock, we received 150$ as a dividend.

ROI=((Current Price+Total Dividends Received/Original First Price)-1) x 100

In this case, the ROI or the total return on your investment will be:

((1,200$+150$/1,000$)-1) x 100 

= 35%

As you can see, once you added extra income rather than your capital gain only, your ROI has increased from 20% to 35%.

Annualized ROI Calculation

One of the most significant drawbacks of ROI is that it does not take time into account. For example, a return on investment of 20% over 10 years is expressed the same as 20% over 10 days. And we can all agree that a 20% return for 10 days is far much better than for 10 years, right?

That is why you can upgrade your calculation and make your ROI normalized regarding the time taken into consideration for the measure itself.

ROI= [(Ending Value / Original First Price) ^ (1 / # of Years)] x 100

Suppose you have your time expressed in days. In that case, you should calculate the number of days between the starting date (day of purchase or day of investment) and the ending date (day of selling or day of returning income). 

Afterward, you should divide the amount by 365. Accordingly, if you have a monthly income, you should divide it by 12. Thereafter, that number should be implemented in the calculation of time.

# of years/days = (Ending date – Starting Date) / 365

For instance, an investor buys a stock on May 1st, 2020, for $12 and sells it on September 25th, 2020, for $15. In this case, we should follow this calculation: 

 [((15$/12$)-1) ^ ((September 25 – May 1)/365)] – 1 = 0,25 ^ (147/365) x 100 = 74 %

In this example, we normalized our ROI for the 147 days that took us to get that return on investment. This helps us to see a more objective picture of our investments’ return. 

ROI Formula Calculator

If you want to analyze on your own, use our free ROI calculator which due to its simplicity and user-friendly design, everyone is able to take advantage of it. You just need to input your own numbers and see the difference between various scenarios.

The calculator covers all four ROI approaches – net profit, capital growth, total return, and annualized return. The best way to gain an understanding of the difference between the four different approaches is to first understand their concept and input numbers to see the calculation is performed.

The Bottom Line 

Return on investment is essentially a way to measure and quantify the value of an investment and its associated risk. To be successful in finance, business, marketing, and many other fields, it is important to understand the concept of ROI and be able to calculate it.

You’ve learned what return on investment is, why it is important and you’ve got strategies to calculate ROI for your company. With all this knowledge it’s up to you now to determine which of the listed approaches suits the best for your company or organization.