ROI Formula, Calculation, and Examples of Return on Investment

[Maliha Islam]

ROI Formula, Calculation, and Examples of Return on Investment

ROI Formula
There are several versions of the ROI formula, the most common two all listed below:

ROI = Net Income / Cost of Investment

or

ROI = Investment Gain / Investment Base

The first version of the formula (net income divided by the cost of an investment) is the most commonly used ratio.

The simplest way to think about the formula is taking some type of “benefit” and dividing it by the “cost”.  When someone says some has a good or bad ROI it’s important to ask them to clarify exactly how they measure it.

Example of ROI calculation
An investor purchases property A which is valued at $500,000; two years later, the investor sold the property for $1,000,000.

We use the investment gain formula in this case.

ROI = (1,000,000 – 500,000) / (500,000) = 1 or 100%

The Use of ROI Calculation
ROI calculations are simple and help the investor decide whether to take or skip an investment opportunity. The calculation can also be an indication of how an investment has performed to date. When an investment shows a positive or negative ROI, it can be an important signal to the investor about their investment.

Using an ROI calculation, the investor can separate low-performing investments from high-performing investments.  With this approach, investors and managers can attempt to optimize their portfolio of investments.

Benefits of ROI
There are many benefits to using the return on investment ratio that every analyst should be aware of
 

#1 Simple and Easy to Calculate
The return on investment metric is frequently used because it’s so easy to calculate.  Only two figures are required – the benefit and the cost.  Becuase a “return” can mean different things to different people it makes the formula easy to use as there is not a strict definition of “return”.

#2 Universally Understood
Return on investment is a universally understood concept and so it’s almost guaranteed that if you use the metric in conversation people will know what you’re talking about.

Limitations of ROI
While the ratio is often very useful, there are also some limitations that are important to know about.  Below are two key points that are worthy of note.

#1 Disregards the Factor of Time
A higher ROI number does not always mean a better investment option. For example, two investments have the same ROI of 50%; the first investment is completed in three years, while the second investment needs five years to produce the same yield. The same ROI for both investments blurred the bigger picture, but when the factor of time was added, an investor can easily see the better option.

The investor needs to compare two instruments under the same period and same circumstances.

#2 Susceptible to Manipulation
An ROI calculation will differ between two people depending on what formula is used in the calculation. A marketing manager can use the property calculation explained in the example section without it accounting for additional costs, such as: maintenance costs, property taxes, sales fees, stamp duties, and legal and inspection cost.

When presented with different investment ROIs, the investor needs to take the true ROI, which accounts for all possible costs incurred when each investment increases in value, into consideration.

Annualized ROI
As mentioned above, one of the drawbacks of the traditional return on investment metric is that it doesn’t take into account time periods. For example, a return of 25% over 5 years is expressed the same as a return of 25% over 5 days. But obviously, a return of 25% in 5 days is much better than 5 years!

To overcome this issue we can calculate an annualized ROI.

Formula:
= [(Ending Value / Beginning Value) ^ (1 / # of Years)] – 1

Where;

# of years = (Ending date – Starting Date) /  365

For example, an investor buys a stock on January 5th, 2017 for $12.50 and sells it on August 24, 2017 for $15.20. What is the regular and annualized return on investment?

Regular = ($15.20 – $12.50) / $12.50 = 21.6%

Annualized = [($15.20 / $12.50) ^ (1 / ((Aug 24 – Jan 5)/365) )] -1 = 35.5%

Alternatives to ROI
There are many alternatives to the very generic return on investment ratio.

The most detailed measure of return is known as the Internal Rate of Return (IRR) which is a measure of all the cash flow received over the life of an investment, expressed as an annual percentage (%) growth rate. The metric takes into account the timing of cash flow, which makes a preferred measure of return in sophisticated industries like private equity and venture capital.

Other alternatives include Return on Equity (ROE) and Return on Assets (ROA).  These two ratios don’t take into account the timing of cash flow and represent only an annual rate of return (as opposed to a lifetime rate of return like IRR), however, there are more specific the generic return on investment since the denominator is more clearly specified.  Equity and Assets have a specific meaning, while “investment” can mean different things.

Source: https://corporatefinanceinstitute.com/resources/knowledge/finance/return-on-investment-roi-formula/