What Is Return on Investment (ROI)?
Return on investment (ROI) is one of the most common financial metrics used to measure and evaluate the profitability of an investment.
How to Calculate Return on Investment (ROI)
To calculate return on investment, all you have to do is divide the net income of an investment with the cost of investment.
The result is either expressed in a ratio or as a percentage. The higher the ratio for return on investment, the more efficient the investment.
ROI = Net income/cost of investment
Here are some of the benefits to using ROI as a metric to measure the efficiency of an investment made by a company.
The return on investment metric is frequently used mainly due to the ease of calculation.
It is straightforward and simply calculated by taking into consideration two variables – the benefits/profits of an investment and the cost of investment.
The return on investment is also versatile as it can be applied to different aspects.
For example, return on investment can be used to measure stock investment or investment into the expansion of a business operation.
- Easy to interpret and compare
Aside from the ease and versatility of return on investment, it is also easily interpreted and compared. If an investment’s return on investment is positive, it is probably worthwhile for investors to consider the investment.
However, if there are other opportunities that offer a higher return on investment, it can help investors to make a decision on the best investment options.
As for negative return on investment, investors might be best to avoid these investments as it indicates losses.
Limitations of ROI
While it is easy to use return on investment, this comes at the costs of some limitations.
One of the problems with return on investment is that the time factor has not been taken into consideration. A simple example is this. Two investments, A and B, have the same return on investment of 25%. However, investment A is completed in two years while investment B requires four years to produce the same return. Under this circumstances, investors would be better off to invest into investment A despite of the same return on investment. Investors need to take into consideration of the time period of the investment.
- Susceptible to manipulation
When looking at return on investment, it is important to understand the breakdown that leads to the return on investment or net income of the investment.
A marketing person might be inclined to calculate the return on investment without taking into consideration additional costs.
This will lead to a higher return on investment. Investors need to look at the true return of the investment by taking into consideration any additional costs.
What is a good ROI?
Now that you’ve learned about the calculation, benefits and limitations of using ROI to measure the efficiency of an investment, it is time to learn what would be seen as a good ROI number.
The short answer is that a higher return on investment is more beneficial to investors. However, one needs to look at the risk tolerance and time period that are expected to generate a return from the investment.
In general, investors with a lower risk tolerance are likely to accept lower ROIs in exchange for stability. Similarly, investors with a higher risk appetite will require a higher return on investment.
Bottom line for investors
Aside from that, it is also important for investors to compare the ROI of a company with its industry peers.
This will help investors to identify if there are any leakages within a company or if it falls under the outliers as compared to its peers.
