If you’re in the world of business or investment, one of the terms you’ll often encounter is Return on Investment or ROI. It’s one of the most important performance metrics, and it’s useful in determining if your initial investment has yielded a profit or incurred a loss. This article will teach you how to calculate ROI.
What is a Return on Investment?
People invest in hopes of turning a profit. But in the realm of investments, it’s not just about generating profit. It’s also about how much profit you generate. This is where ROI comes into play. Investopedia defines it as “a ratio that compares the gain or loss from an investment to its cost.”
Note that the higher the ratio, the higher the gain. In terms of stock investments, an ROI of 7 to 10 percent is considered good. For a rental property, it’s 8 to 12 percent. According to CSIMarket, the industries that boast some of the highest ROI figures are energy (18.16 percent), technology (17.54 percent) and retail (10.68 percent).
How to calculate ROI
If you’re an investor evaluating your portfolio or an entrepreneur assessing the profitability of a product or a service you bought (e.g., a machine or third-party marketing services), knowing how to calculate ROI is a piece of valuable knowledge. And since ROI is shown as a percentage, you can easily compare how good or profitable different investments are.
But how do you compute it? Here are two methods.
Method 1:
The first method uses this formula: ROI = (Net profit ÷ Initial cost of investment) x 100.
For example, you bought shares from a company worth AED30,000. After a month, you sold it for AED40,000, which is your gross profit. In the process, you incurred fees and charges worth AED5,000. To compute your ROI, follow these steps:
- Get the net profit by adding your initial investment cost and other expenses and subtracting it from your gross profit. For the example above, it will be 40,000 – (30,000 + 5,000) = 5,000.
- Now that you have the net profit, you can get the ROI. Since your net profit is AED5,000 and the initial cost of your investment is AED30,000, the equation will look like this: ROI = (5,000 ÷ 30,000) x 100.
- Compute the ROI. The final result will be 16.67 percent.
Method 2:
In the second method, this is the formula you’ll use: ROI = [(Final value of investment – Initial cost of investment) ÷ Initial cost of Investment] x 100.
For example, if you bought a land worth AED500,000. You’ve finally decided to sell it and after taking into account all expenses, you earned AED600,000 from it. Following the formula above, you can compute your ROI by following these steps.
- Determine the values you’ll use in the formula. In this case, the final value of your investment is AED600,000 and the initial cost of your investment is AED500,000.
- Plug in all the values in the formula. It will be like this: [(600,000 – 500,000) ÷ 500,000] x 100.
- Compute the ROI. You will get 20 percent as the answer.
Read: How to calculate your business’ year-over-year growth
Pros and cons of ROI
ROI has its own benefits and limits. Knowing these will guide you on how to use ROI alongside other key performance indicators.
Pro: It’s a universal concept
Most people will know what you are talking about if you talk about ROI. It’s also intuitively simple to understand: It’s the gain (or loss) you incur from an investment. Even if someone is unfamiliar with it, they can easily comprehend it.
Pro: It’s easy to compute
Either formula you use, getting your ROI is a fairly straightforward process. It all boils down to getting and plugging in the right data.
Con: ROI doesn’t take time into account
If you look at any of the formulas above, you’ll notice that there’s no time considered. And this can be an issue if you compare investments. For instance, if two investments generated a 25 percent ROI, the better investment would be the one that yielded that figure in a shorter period.
Con: It can be manipulated
Note that the formulas use net profit and the final value of the investment. Anyone can manipulate it by deliberately not factoring in additional costs like fees incurred when selling stocks. Intentional or not, failure to consider such things can lead to erroneous ROIs.
Final thoughts
Knowing how to calculate ROI is an indispensable skill in business and investing. You can also use the very concept of ROI when deciding on various things, such as which coffee maker should you buy, or which software subscription to renew.
To arrive at better decisions, you must, however, use ROI in conjunction with other metrics. Many different formulas and performance indicators are there — it’s a matter of using them correctly for a more comprehensive analysis.
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