Business Courses/Intro to Business: Help and ReviewCourse
- AuthorJeremy Cook
Jeremy taught elementary school for 18 years in in the United States and in Switzerland. He has a Masters in Education from Rollins College in Winter Park, Florida. He's taught grades 2, 3, 4, 5 and 8. His strength is in educational content writing and technology in the classroom
View bio - InstructorShawn Grimsley
Shawn has a masters of public administration, JD, and a BA in political science.
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Find out how to calculate the return on investment. View the return on investment formula applied to real-world examples and explore how to analyze ROI.Updated: 11/21/2023
Table of Contents
- What is Return on Return on Investment
- Return on Investment Formula
- Alternative Methods to Calculate ROI
- Limitations of Calculating ROI
- Return on Investment Analysis
- Lesson Summary
Table of Contents
- What is Return on Return on Investment
- Return on Investment Formula
- Alternative Methods to Calculate ROI
- Limitations of Calculating ROI
- Return on Investment Analysis
- Lesson Summary
Return on investment, also known as ROI, is a ratio of either a financial profit or loss. The ratio is expressed in terms of an investment where the increase or decrease of value is shown as a percentage. The ratio is commonly used to determine the probability of making a profit or incurring a loss on a particular investment. ROI can be used by a range of invested parties from large corporations to individual taxpayers. There is no minimum or maximum investment needed to use ROI.
- Example of ROI - Let's say that a person bought a house that needed significant work for $100,000. During the course of a year, they invested an additional $100,000 to renovate the house to make it sellable. They are able to sell the renovated house for $250,000. In this example, the ROI would be 25% assuming that the investor spent no additional money.
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Differentiating Return on Investment (ROI), Rate of Return (ROR), & Profit
There are a few different ways to calculate the success or failure of an investment. Each calculation method uses a slightly different approach to how an investment is calculated. The table below provides an example of each method.
| Investment Calculation Method | Description | Formula | Example |
|---|---|---|---|
| Return on Investment | ROI gives the investor simple knowledge on how much money will be made for every dollar they spend on inventory | Net Profit/Total Investment | If an investment has an ROI of 10%, the investment will return $1.10 for every $1 spent |
| Rate of Return (ROR) | ROR looks at the investment over a period of time and calculates it based on the initial cost versus what the current value is. | Current Value-Initial Value/Initial Value X 100 | Stock is purchased for $1,000. After six months, the stock is worth $1,200. The ROR would be 20%. |
| Profit Margin | Profit Margin, unlike ROI, is based on the total price that the investment was sold at. It can never be greater than 100% | Profit (revenue - costs) / Revenue | A piece of antique furniture is bought for $100 and costs $50 to restore. The piece was then sold for $400; the profit margin would be 62.5% |
Where Can the Average Return on Investment Apply?
- ROI can help investors decide whether an investment has the potential to be profitable. It can also be a tool that helps to compare returns from the past. If an investor is interested in investing in a particular mutual fund, the ROI can go back many years and give a clearer picture of the long-term success of the investment. Since ROI can change over time, it can also help in understanding major disruptions to the investment. A positive ROI percentage would indicate a potential buy, while a negative ROI would indicate a need to sell or stay away from the particular investment.
- ROI is used to compare high and low-performing investments. This helps everyone from financial planners to fund managers choose the best investments.
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- Net Return on Investment/Initial Cost of Investment X 100
- If the percentage that comes out of the ROI formula is a positive number, the investment has gained value. If the value is negative, the investment is a loss.
How to Calculate Return on Investment
It's important to understand the different values of the ROI formula in order to accurately calculate the ROI and interpret the results correctly.
- In the traditional formula, the net return on investment is how much profit the investment made based on the initial value. If the investment was a house, the net return on investment would be the amount made on the house after the initial investment was deducted. The initial cost of investment is how much it cost to buy into the investment.
The formula for the house investment would look like this:
$50,000/$100,000 X 100 = 50
The initial investment is misleading and can be a manipulated number. In the example of the house, the initial cost was $100,000 for the house, but the investor had to add an additional $100,000 for renovations.
How to Calculate ROI for Specific Expenses
The traditional ROI formula is simplistic and can often be misleading because it can leave out expenses that come after the initial purchase. There is a slightly more complex ROI formula that takes into account the expenses that the investor incurred after they spent the initial money for the investment. Depending on the investment, expenses can include any cost such as materials, labor, fees, salaries, and taxes. The expanded ROI formula looks like this:
(Final Value of Investment-Initial Value Investment)/Total Cost of Investment X 100
In the example of the traditional formula, the $100,000 that was spent to renovate the house would be added to the formula and would change the ROI from a 50% return to a 25% return.
With the addition of the total cost of investment, the formula takes into account all the expenses associated with the investment along with the initial cost. This formula gives a clearer picture of how much total money was spent. Let's assume that an investor bought a share of stock for a total of $100 and sold it for $150. Traditional ROI would calculate the investment return as 50%. But if the investor had to pay a commission of $5 to trade the stock, the ROI would actually be 45%. The above formula would reflect the 45% and not the 50% of the traditional ROI.
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There is another formula that can be used as an alternative to the traditional ROI calculator. The method involves taking into account periods of time. The traditional ROI and the ROI that takes into account expenses do not reflect any periods of time.
Annualized ROI
Traditional ROI doesn't take into account periods of time. This means that an investor who made a 20% ROI over the course of three years would have the same percentage as the person who made the same amount in three months' time. The percentage is the same, but the person who made the 20% in 3 months clearly had a better investment.
The annualized ROI formula adds in values for time periods, which can provide deeper insight into the value of an investment.
Annualized ROI Formula:
= (Ending Value / Beginning Value) ^ (1 / # of Years) - 1
The # symbol means the number of years, which is calculated by subtracting the start date from the end date and dividing the results by 365. (Ending date - Starting Date) / 365
Annualized ROI is most applicable for investing in financial products like stocks, mutual funds, and bonds. Let's assume that a person buys a stock on January 1st for $12.50 and turns around to sell it for $15.20 on August 24th. The ROI will look very different when the annualized rate of return is used. The two formulas below show the calculations using normal ROI and annualized ROI.
- Regular ROI = ($15.20 - $12.50) / $12.50 = 21.6%
- Annualized ROI= ($15.20 / $12.50) ^ (1 / ((Aug 24 - Jan 1)/365) )-1=35.5%
The annualized ROI shows a much higher percentage due to the time period that was inserted. The larger the value of the period of time, the lower the ROI. There will be a point in time when the annualized ROI will drop below the regular ROI.
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There are two major limitations of the traditional ROI formula and each limitation has a different effect on the way the ROI is viewed and evaluated.
- Traditional ROI doesn't take time into account - The annualized ROI is a way to fix the limitation of ROI, but when traditional ROI is used, it becomes a major limitation. Without taking time into account, ROI can be misleading. If an investor buys a stock for $10 per share and sells it 10 years later at $20 per share, the ROI would be 100%. But that's over 10 years. If the same stock was bought and sold for 100% ROI in 3 days, it would be a much better return.
- Traditional ROI can be misleading - Since the traditional formula is simple and only takes initial cost and net return into account, it's easy to exclude expenses. Consider the example of a person buying a house for $100,000 and spending $100,000 to renovate the house. If the house sold for $250,000 the return on investment would be 50% according to traditional ROI. But the investor also paid $100,000 to renovate and most likely would have to pay a realtor fee for the sale of the house. If that fee was 5%, along with the $100,000 invested for renovation, the return would be dramatically lower. Someone could leave out the fee and the renovation expenses from the traditional ROI because it technically doesn't take into account the expenses and fees since they were not part of the initial investment.
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ROI analysis is the basic understanding of the numbers that the ROI formulas produce and being able to interpret them in comparison to other investments. There are two basic means of ROI analysis.
- The first analysis compares ROI with a common financial element. If two companies exist in the same market, you can compare their ROIs to get an idea of which company is more profitable and therefore would be a better financial investment.
- The second way to analyze ROI is to break down the ROI into separate parts and look at each individually. This is a more complex method, but it often results in a more complete analysis. There are two parts of ROI called asset turnover and profit margin. Asset turnover is the ratio of total revenue to total assets. Profit margin is the ratio of a company's profit, which is revenue minus expenses, and total expenses.
When potential investors use the second method, they are able to get a much clearer financial image of a company, especially with regards to assets and expenses.
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Return on investment or ROI is a formula used to calculate the potential profit or loss of a particular financial investment or institution. Traditional ROI is calculated with a simple formula of:
- Net Profit/Initial Investment X 100
The outcome will be a percentage that can be used to determine how profitable something is. ROI can be used to determine the investment potential of a stock, a potential business investment, or any other type of financial undertaking. There are three different formulas to calculate ROI and each one takes into account different elements.
| ROI Formula | Attribute |
|---|---|
| Net Profit/Initial Investment X 100 | This traditional ROI only takes into account the initial cost of the investment compared to the return. |
| (Final Value of Investment-Initial Value Investment)/Total Cost of Investment X 100 | This ROI takes into account any expenses that occur after the initial investment |
| (Ending Value / Beginning Value) ^ (1 / # of Years) - 1 | Called annualized ROI, it takes into account time periods between the initial investment and the sale of the investment. |
ROI can be a useful financial tool for determining if an investment will be profitable. It also has some limitations:
- ROI can be too simplistic; unless the annualized formula is used, it can be deceiving because it lacks periods of time.
- ROI can be manipulated by people presenting the information because it can be calculated without including expenses incurred after the initial investment.
The process of understanding ROI and looking at the ratios in depth is called ROI analysis and is a crucial part of using ROI for financial education and potential gain.
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Video Transcript
ROI Defined
Return on investment (ROI) is the ratio of a profit or loss made in a fiscal year expressed in terms of an investment. It is expressed in terms of a percentage of increase or decrease in the value of the investment during the year in question. For example, if you invested $100 in a share of stock and its value rises to $110 by the end of the fiscal year, the return on the investment is a healthy 10%, assuming no dividends were paid.
Basic ROI Formula and Example
The basic ROI formula is: Net Profit / Total Investment * 100 = ROI. Let's apply the formula with the help of an example.
You are a house flipper. You purchased a house at the courthouse auction for $75,000 and spent $35,000 in renovations. After sales, expenses, and commission, you netted $160,000 on the sale of the renovated house. What is the ROI?
Your net profit is going to be what you netted ($160,000) minus what you spent ($75,000 + $35,000), so it is $50,000. Your total investment is also what you spent ($75,000 + $35,000), which is $110,000.
ROI = Net Profit / Total Investment * 100
ROI = 50,000 / 110,000 * 100
ROI = .45 * 100
ROI = 45%
If only house flipping was that easy. Keep in mind that you can certainly lose money on an investment. If there is a loss, the formula will yield a negative number. Here's a simple example:
ROI = -1,000 / 5,000 * 100
ROI = -0.2 * 100
ROI = -20%
Shareholders can calculate the value of their stock investment in a particular company by use of this formula: ROI = (Net income + (Current Value - Original Value)) / Original Value * 100.
Let's say you have stock in a tech company. You originally purchased the shares for $5,000 and they're now worth $5,200. You've also been paid $75 in dividends. What is your ROI for this stock holding?
ROI = (Net Income + (Current Value - Original Value)) / Original Value * 100
ROI = (75 + (5,200 - 5,000)) / 5,000 * 100
ROI = (75 + 200) / 5,000 * 100
ROI = 275 / 5,000 * 100
ROI = .055 * 100
ROI = 5.5%
Lesson Summary
Return on investment, or ROI, is the ratio of a profit or loss made in a fiscal year expressed in terms of an investment and shown as a percentage of increase or decrease in the value of the investment during the year in question. The basic formula for ROI is: ROI = Net Profit / Total Investment * 100. Keep in mind that if you have a net loss on your investment, the ROI will be negative. Shareholders can evaluate the ROI of their stock holding by using this formula: ROI = (Net Income + (Current Value - Original Value)) / Original Value * 100.
ROI Notes
- ROI is 'return on investment', the ratio of profit or loss made in a fiscal year
- Basic ROI can be calculated as ROI = Net Profit / Total Investment * 100
- A shareholder can evaluate the ROI of their stock as ROI = (Net Income + (Current Value - Original Value)) / Original Value * 100
Learning Outcomes
When you are finished, you should be able to:
- Define 'return on investment'
- State the equations used to calculate basic ROI and shareholder ROI
- Use the formulas to calculate ROI
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