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What Is ROI? Return On Investment Explained

Let’s be honest. When you invest money, you have a goal in mind and that goal is to make a profit. It is important to understand the efficiency of your investment and to do so you will want to check it’s ROI (return on investment).

A return on investment is a financial formula that calculates the percentage of profit you received, relative to the capital cost. In other words, ROI measures what you receive back compared to the investment you put in.

How Does ROI Work?

Calculating your return on investment will help you measure what is working and what is not. This calculation is simple and one of the most popular metrics for gauging investment profitability. 

How Do You Calculate ROI?

Calculating your return on investment is not complicated. In fact, it is a very simple formula.

Investment Gain/Cost of Investment = ROI

The formula is measured as a percentage, allowing you the ease of comparing one investment to various others. Tracking ROI can help you select similar investment opportunities that will likely have other net positive ROIs. Or it can help you avoid and eliminate investments that have negative ROIs (a net loss).

Example Of An ROI Calculation

Suppose you invested $2,000 in Company A. A year later, you decided to sell your stock shares for $2200. To calculate your ROI, you would divide your profits ($2,200 – $2,000) by the total investment cost ($2,000). Your ROI ($200/$2,000) equals 10%.

Using ROI calculations can help you as an investor decide if you want to take or skip an investment opportunity. It is also a good indicator for how your current investments are performing to date. 

What Is A Good ROI?

There isn’t a one-size-fits-all guide to what is considered a “good” ROI. Instead, it depends on various factors.

The first factor to consider is your current life stage. If you’re a young investor working to build your retirement savings, your definition of a good ROI will vary compared to a retiree who is looking to supplement their income. Of course, what is considered a good rate of return will always be a net positive ROI.

While what is considered “good” for ROI can vary across the board depending upon your investment needs, many in the financial industry view an average annual return rate of 10% or more to be a good return on investment. 

What Industries Have The Best ROI?

When looking back on historical data, from 1965 to 2020, S&P 500 has had an average ROI of 10%. Although, there is a caveat to it. In 2018, the annual return had a -4.4% net loss, whereas 2019 had a 31.5% net positive. When broken down individually, technology companies had the greater returns, most well above the average 10%. Companies including Apple Inc., Microsoft Corp., and Amazon.com Inc. all generate high returns.

Alternatively, companies within the energy and utility sector had much lower ROIs and many faced year-after-year loss. It’s also important to note up and coming industries when you’re considering stock or fund investments. Biotech, artificial intelligence, marijuana, and other groundbreaking industries can provide you with favorable ROIs.

What Are The Limitations Of ROI?

While ROI is a fantastic metric to provide a quick snapshot at the efficacy of your investment, it does come with limitations. The first being it can encourage myopic investing. You or your financial planners could begin to focus on short runs instead of focusing on long term strategies. As aforementioned, some years you will see, and average ROI take a net loss. However, the long-term ROI could have very well paid off with a high net positive.

Additionally, there is no “right way” to calculate ROI – profit after deducting costs, gross value, net value, current cost of asset, assets including or excluding intangible assets, are all variables that will need to be considered when calculating your ROI. You also need to take into account the gestation period of each investment. 

Alternative Ways To Calculate ROI

There are various ways to calculate your return on investment. This includes real rate of return, return on equity (ROE), net present value, return on assets (ROA) and annualized ROI. Each serves their own purposes to help you determine the success of your investment.

Real Rate Of Return

The formula for real rate of return provides you with the percentage your profit achieved, adjusted for inflation. Inflation commonly reduces the value of money as time passes, often by 2-3% per year. This could make your investments less impressive after the adjustments.

Return On Equity

The return on equity (ROE) formula shows how much profit a firm or company earned compared to the total amount of shareholder equity on the balance sheet.

Net Present Value

When calculating the net present value, the difference between net cash outflows and net cash inflows over time, you will determine the current value of future cash flow. This formula is beneficial for financial modeling and analysis to determine the value of an investment (a stock, a project, a company, etc.). 

Return On Assets

The Return on Assets (ROA) metric measures how efficiently the assets are managed to produce profits during a given period. It compares the profitability produced from your assets to the average total assets during a set timeframe.  

Annualized ROI

When making an investment there are variables including time. Many investments last a few years, months, or some even just a few days. Others can last for decades. With these investments, it can become harder to compare based on their return rates due to these variable gestation periods. Annualized ROI resolves that problem.

While traditional formulas calculate how much you will get back on your investment, annualized ROIs are adjusted to fit a period of one year. Different investment opportunities of various lengths can be compared in a common format by utilizing annualized ROI.

Utilizing ROI To Make Helpful Comparisons

When you make multiple investments, you will need to analyze and compare each one to ensure your strategies are paying off. Using calculations like return on investment, annualized ROI, and other key metrics can help you compare and get the most out of your assets.

If you’re unsure where to start, check with your financial advisor to go over these financial formulas. They will help make sure you are investing effectively and provide you with proactive tips to show you the roadmap to investing properly.