Wondering what is ROI? Here’s a comprehensive guide on what R.O.I. means, its calculation, and the features, pros, and cons of the average return on investment.
Introduction
Return on investment (ROI) is a percentage of return used to mathematically calculate how well an investment is performing compared to others.
The ROI calculations of a business or your investment portfolio help you assess whether your immediate goals have been achieved. When in business, your ROI could be profits, building infrastructure, expanding business opportunities, or increasing sales.
What is ROI in the case of investments? Well, it’s the return you get on the invested amount. ROI is calculated as a percentage depicting the immediate profit or cost savings.
What is ROI?
Return on investment helps calculate the profitability of an investment and is used to compare one investment to another. ROI measures the amount of return you earn from one investment, which also considers the cost of the investment.
ROI comparisons can help rank investments by considering other factors like the cost incurred on the investment and tenure.
In short, ROI return investment is the basic measure of investment profitability accounts which are relatively easy to interpret for a wide range of applications. If the ROI of your investment is positive, it’s worth the investment.
Alisah invested NGN 10,000 in the stock market and sold her stocks for NGN 15,000 in 2021. The net profit would be NGN 5,000. You can get the R.O.I. percentage if you divide the profit by the investment cost. In this case, 5,000/10,000 x 100, or 50%.
With this information, you can compare the investment returns on different investments and see which ones are profitable and which aren’t. It becomes easier to weed out the investments that aren’t bringing profits and stick to those that generate high investment returns.
How to Calculate ROI?
The formula for calculating ROI return investment is:
ROI= Net Return on investment/Cost of Investment × 100%
Or
ROI= FVI−IVI/Cost of Investment ×100%
Where:
- Final value of an investment
- IVI=Initial value of an investment
It becomes easy to compare investments as the average return on investment is represented as a percentage. Let’s take a quick example:
Joseph invested NGN 5000 in mutual funds and another NGN 5000 in a bank deposit account. After one year, the mutual fund’s deposit generates a value of NGN 6000, whereas the bank deposit becomes NGN 5500.
To compare the ROI return investment on both, we must calculate the percentage for both first:
ROI on Mutual funds (6000-5000) 1000/5000 (initial cost) x 100% = 20%
ROI on Bank deposit (5500-5000) 500/5000 (Initial cost) x 100% = 10%
So, if we compare the ROIs of both investment products, we can see that investment in mutual funds is a better deal than bank deposits (without considering other factors)
However, you must note that this simple ROI return investment calculation does not include the tenure of the investment. Thus, it’s better to calculate the annualized ROI for every investment, which also considers the tenure and can give a better picture.
The Formula for Calculating Annualized ROI Return Investment
Annualised ROI=[(1+ROI)1/n−1]×100%
Where n=Number of years investment is held
Let’s take another example here:
Alizeh invested NGN 5000 in mutual funds for 5 years, and the amount she got as a return was NGN 7000. She also invested NGN 5000 in a dollar case for 2 years and got NGN 6500.
Let’s calculate the annualized return for both investments and see which one has generated a higher return:
Annualised ROI return investment on mutual funds =[(1+2000)1/5−1]×100%
- Investment Gain $2,000.00
- ROI 40.00%
- Annualized ROI 6.96%
Annualised ROI on dollar case=[(1+1500)1/2−1]×100%
- Investment Gain $1,500.00
- ROI 30.00%
- Annualised ROI 14.02%
So, comparing the ROI on both investments shows mutual funds’ investments are a better deal.
However, when you use the annualized ROI formula, which also considers the time frame, it’s clear that investing in a dollar case is a much more lucrative option that generates a much higher average return on investment than mutual funds.
Using the annualized ROI return investment is always recommended when comparing investments.
How to Use ROI?
ROI is a simple way to calculate and measure the profit or loss of current investments. It’s always better to calculate the annualized ROI for a product/investment, which makes it easier to assess its revenue generation in one year.
What is ROI Used for?
ROI is best used for comparing two different investments to their initial cost and assessing the profitability of past or future investments.
Before investing in any category, the ROI must be considered first. If you know an investment is profitable and generates higher ROI, you should invest in that.
On the other hand, an asset that doesn’t guarantee and generates a low R.O.I. return investment should not be invested in.
What are the Benefits of ROI?
ROI calculation has several benefits. It helps you decide what to invest in and what to avoid. You can anticipate the investment returns using the ROI return investment percentage and evaluate investment performance.
- ROI is a standardized way that helps you compare investments and requires only a few variables to complete the calculation.
- It’s an extremely beneficial tool that can be used on your balance sheets and business financial statements, which can help you assess the profitability of your business.
- ROI is widely used and easy to calculate because it’s more comparable across organizations.
- ROI refers to the net return on investment in a particular business unit. This allows you to measure the profitability of your company or team more accurately.
What are the Limitations of ROI?
One of the biggest limitations of average return on investment calculations is that they don’t consider the tenure of the investment.
You may get the wrong picture if you look at Alizeh’s investments and consider only the ROI factor. In such cases, it is suggested to use ROI return investment only in cases where the time or tenure of the investment is the same.
- So, considering the above example, it is clear that when the annualized ROI based on the holding period is considered, the second investment, which showed a lower ROI, is the actual one that gives a much higher annualized ROI.
- ROI should be used with the rate of return (RoR) or net present value (NPV). This accounts for inflation-related monetary value variances over time.
- ROI calculations vary by company. Since there are different formulas for calculating ROI, not all companies use the same formula, and comparisons between investments might be meaningless.
- Generally, while pouring funds into an investment, the fund managers select investments with higher ROI. Even an investment with a low average return on investment can add value to your company. However, suboptimal decisions can lead to poor resource allocation.
- Non-monetary investment returns are not considered while calculating ROI return investment. If you purchase a new technology, a tablet or a smartwatch, it’s difficult to estimate the return this asset generates, as it’s not in the monetary form.
- However, a company can calculate the ROI of such intangible profits by referring to them as soft ROI, whereas those involving a tangible amount are called hard ROI.
What are the Alternatives to ROI?
Other alternatives for ROI return investment that investors and organizations to measure and compare include:
- Annualized ROI
As discussed earlier, this form of his ROI considers the period in which the stakeholder invested.
Here’s an example of calculating annualized investment returns:
Annualized ROI = ((final investment value – initial investment value) / initial investment value) x 100. )^( 1/n) – 1
Here, P is the initial investment, G is the profit or loss, and n is the investment number of years owned.
- Social ROI (SROI)
SROI is results-oriented and considers the wider impact of economic, environmental, and social values. You can convert these results into tangible monetary amounts.
The calculation for SROI = net present value of profit/net present value of the investment.
- ROI for Social Media Statistics
This is considered to measure the effectiveness of your social media campaigns and may include the number of views and likes generated.
A simple math to measure the time, money, and resources spent on social media average return on investment in terms of sales is (value / total investment) x 100.
- ROI for Marketing Statistics
This is considered to measure the effectiveness of your marketing campaign strategies or programs.
The basic calculation is (sales growth – marketing cost) / marketing cost.
What are the Developments in ROI?
During the 1990s, investors and companies became interested in developing a new form of ROI called “social return on investment,” or SROI.
This metric uses non-financial values (social and environmental indicators not currently considered in traditional financial accounts) to consider the broader impacts of projects.
This valuable metric considers specific environmental, social, and governance (ESG) criteria valid in socially responsible investment (SRI) practices. These ventures have direct costs that can negatively impact traditional ROI, but net benefits to society and the environment can lead to positive SROI.
Another development in ROI is marketing-based or social media statistics-based ROI, which shows the return or profit you attain after investing your time in marketing and social media posts.
This ratio shows the effectiveness of your social media campaigns and seeks to identify the return attributed to an advertising or marketing campaign.
It is anticipated that as the world progresses, several more average return on investment metrics will be developed to decipher the return in both tangible and intangible forms to calculate and compare different options.
Conclusion
ROI is a comprehensive, easy calculation that helps you compare investment options. However, it considers neither risk nor time horizon and should be used with another metric to measure all costs accurately.
ROI can be used as a good starting point but is not the only factor to consider when investing. ROI ascertains the profitability or loss of your investment, but it does not consider the period of investments and is not risk-adjusted.
Despite all the drawbacks, average return on investment is one of the most widely used metrics by investors, businesses, and organizations to compare and rank investment choices.
FAQs
What Is ROI in Simple Terms?
ROI, in simple terms, is a general calculation of the profit or loss you have made out of an investment, whether it is in the stock market, business, real estate, Gold, or any other product where you have put in some money, after taking costs into account.
How Do You Calculate Return on Investment (ROI)?
Return on investment (ROI) is a simple percentage calculation that divides the profit earned from an investment (return) by the initial cost of the cost and multiplies it by 100%.
So, if you invest 5000 Naira in real estate and get 10,000 Naira after 10 years, this simply means that in 10 years, the average return on investment in real estate is 100%.
ROI is a quick and easy way to measure investment success; however, it doesn’t consider many aspects like the time your money has been invested, the costs you incurred on the investment, depreciation, etc.
This is one reason investors consider other calculations like internal rate of return (IRR) and net present value (NPV) along with ROI to find accurate investment returns.
What Is a Good ROI?
A “good” ROI depends on many factors, such as the time it takes for an investment to generate returns and your risk. If you are a risk-aversive investor, you may accept a lower average return on investment and liquidate your investment quickly.
A person who likes taking risks can keep the investment locked for years and generate a much higher ROI, which is quite attractive in the investing world. Thus, an ROI is considered good when correlated with the time invested.
Which Industries Have the Highest ROI?
Industries that are a part of the S&P 500 have delivered around 10% ROI annually, but this varies significantly by industry. Lately, technology companies are generating a much higher ROI year on year, while sectors like energy or utilities are generating a lower average return on investment.
However, this situation can change, considering internal and external factors like competition, government rules and regulations, evolving technology, and changing consumer preferences.