Return on investment is a key financial metric with a range of valuable uses. Most financial concepts in the business world are based on this metric. This article will explore the return on investment as a concept, different ways to calculate it, and the advantages and shortcomings of this metric. Examples will be used to explore the topic as well.
Key Takeaways
- Return on investment is a metric that shows the approximate profitability of an investment.
- It’s calculated by simply finding the ratio between the net return on investments and the cost of investment.
- ROI can be positive or negative. If it’s negative, the investment has resulted in a loss.
- ROI is a basic and helpful metric, but it fails to consider certain costs and metrics like time, which can affect investors’ interest.
What is the return on investment?
Return on investment or ROI is a financial metric that depicts the profit of an investment after considering its costs. Also, investors use this metric to make financial decisions regarding investing in companies or brands.
A company’s prospective investors may compare similar businesses’ returns on investment before deciding which companies to invest in. ROI is a standard, easy-to-understand metric that’s unlikely to be misunderstood.
Most financial concepts are built on the ROI as it indicates how much money an investor can make in the future if they consider investing right now.
The return on investment is also a good indicator of how a company is managed and how its financial decisions are driven.
How to Calculate the Return on Investment
Return on investment is calculated using either of the following formulas.
Return on investment = (net return on investment / cost of investment) x 100%
Return on investment = ((Final value investment – Initial value investment) / Cost of investment) x 100%
Example 1
An investor bought 500 shares of a startup technology company that is dedicated to providing customers with data-based tech solutions. Each share cost him US$ 10. 2 years later, the investor sold off all 500 of his shares at US$12 a share. He had received US$ 1000 as dividend income in said 2 years. He had also spent US$ 200 in trading commissions when selling the aforementioned stocks. This investor’s return on investment is calculates as such.
= ((((US$ 12 – US$ 10) x 500) + US$ 1000 – US$ 200) / (US$ 10 x 500)) x 100%
= 36%
Example 2
A businessman had invested in buying 1000 shares of a business, sold at US$ 20 each. The business in question was a series of bars opening up in busy tourist areas in major cities worldwide. The global pandemic struck the business hard, and the value of their stocks plummeted to US$ 8 each. The businessman sold all of his stocks for US$ 8 after 2 years, and he did not receive any dividend during the time he held on to the stocks. He also spent US$ 300 in trading commissions when he sold these stocks to another investor.
= (((US$ 8- US$ 20) x 1000) -300) / (US$ 20 x 1000) x 100%
= -61.5%
Since the investment ended in a loss, the ROI is negative.
Example 3
A florist decides to expand her brand and establish a new branch in a different city. To raise capital for this purpose, she creates shares for her company and sells them at US$ 5 per share. Investors buy one thousand shares. A particular investor buys 300 shares and sells them in 3 years for US$ 18 per share. She bears US$ 400 in trading commissions. How is her ROI calculated?
= (((US$ 18 – US$ 5) x 300) – US$ 400) / (US$ 5 x 300) x 100%
= 233%
What Does a Positive or Negative Return on Investment Tell You?
A positive return on investment indicates that an investment made a profit. It means the returns are greater than the costs. The higher the positive value of the ROI is, the more interested prospective investors are in said investment opportunities.
A negative ROI indicates that a particular investment has costs higher than its returns. This refers to the loss of investments over a period of time.
Avoiding a Negative Return On Investment
- Define success in advance– What success means for investments can differ. It’s important to define success very clearly in advance to take steps towards the specified goal.
- Curate the perfect team in advance– Once a particular goal is defined, choosing the best team to manage and execute the goal is very important. A highly committed and experienced team will make all the difference and aid in avoiding a negative return on investment.
- Look out for early warning signs– Early signs like investors being disinterested in a particular investment may be tell-tale signs of a negative return on investment. Paying attention to these early warning signs and taking steps to fix the recognised problems can avoid a negative ROI or cut losses even within a negative ROI.
Limitations of Return on Investment
- Doesn’t consider holding periods
Return on Investment doesn’t consider the holding period of investment. This can be a problem for investors who want to delve into an analytic comparison of available investment opportunities.
Investment opportunity A can have a return on investment of 25%, and investment opportunity B can have a ROI of 15%. However, opportunity A cannot immediately be ruled out as the better investment option. The 25% ROI could be built up over 5 years, while the 15% ROI could be built up in 6 months. The time frame should also be considered when making investment decisions, and the ROI lacks to tell a prospective investor that.
Annualizing the ROI can help rid this problem.
- Certain Costs Can be Omitted
ROI can be inflated either purposefully or on accident. This can be done by not considering the maintenance costs, rent and taxes related to investments such as real estate. These costs may be omitted because they are unpredictable as well.
- Different companies may use different formulas to calculate ROI.
Summary
ROI is an important metric that can give investors insights into the stocks or businesses they are considering investing in. It can also let businesses identify their shortcomings and help them devise strategies to overcome said weaknesses. Much of the investing world revolves around the concept of ROI. However, this shouldn’t be the only metric considered when either investing or making business decisions, since certain financial aspects are ignored when calculating ROI.