When you invest money into a business, buy shares in a corporation or invest in any other kind of asset, it’s important to know how much you’re gaining or losing.
Return on investment, or ROI, is one of the most important financial metrics to keep track of as an investor or entrepreneur. Below, we’ve explained what return on investment is, why it’s such an important metric and how you can calculate it using a simple formula.
What is Return on Investment?
Return on investment is a metric used to determine how well an investment has performed over a certain period of time. Specifically, return on investment measures the total gain or loss from a specific investment relative to the amount invested.
Like other financial metrics, return on investment can be positive (when your investment makes a profit) or negative (when your investment makes a loss).
Return on investment is commonly shortened to the acronym “ROI” in business documents and news articles.
Although return on investment isn’t the only metric you should look at when judging a business or investment’s performance, it’s extremely useful as a simple gauge of how well an investment is doing.
How is Return on Investment Calculated?
Return on investment is calculated by dividing the proceeds gained from an investment by the total cost of the investment. As a formula, it’s:
ROI = (Net Profit from Investment / Cost of Investment) * 100
In this case, “net profit” refers to the total amount of money earned from the investment, minus the total cost of making the investment.
Here’s an example:
You buy $10,000 worth of shares in a fast-growing, promising company. Three years later, your shares are worth a total of $30,000. You decide that it’s time to sell your shares in the company and keep the profit from your investment.
In this case, the total amount you receive from the sale of your shares. Minus the $10,000 you invested in the beginning, the profit from your investment is $20,000.
Here’s the return on investment formula from above, completed for this example:
ROI = ($20,000 / $10,000) * 100
In this case, the profit is twice as much as your initial investment. This means the total return on investment from your shares is 200%. Thanks to this 200% return on investment, you’re left with three times as much money as you had before investing.
It’s important to remember that your return on investment calculations need to take other costs, such as taxes and fees, into account. For example, if you’re charged a capital gains tax (or any other tax) on your profits, it will usually lower your return on investment.
It’s also important to remember that return on investment only expresses the total return earned from an investment, not the return over a set period of time. If you’re comparing investments to see which performed the best, you’ll need to compare them over the same time period.
Calculating the return on investment for a simple example like above is fairly easy. However, it can become far more complicated to calculate an accurate return on investment after you add different tax rates, dividends, depreciation and other factors into the equation.
The Limitations of Return on Investment
As we briefly mentioned above, there are several factors you’ll need to keep in mind when you calculate an investment’s ROI. This is because ROI itself has several limitations as a metric for measuring financial performance.
First, ROI doesn’t account for an investment’s timeframe. If you’re comparing two investments, one of which covered one year and the other five years, you’ll need to use a metric like rate of return to measure and compare their performance accurately.
Second, ROI doesn’t account for any definition of profit and investment. Profit can be measured in several different ways, from a simple measurement of profit before interest and tax to a more complicated measurement of profit after interest, tax and factors like depreciation.
This means you might need to account for different accounting methods and definitions of profit when you’re comparing investments using ROI.
Finally, ROI doesn’t measure the full amount of profit earned by an investment. This means that small, non-scalable investments can look more appealing from an ROI perspective than larger, potentially more lucrative investments that require more investment capital.
Being able to measure and compare your investments by their total return on investment is an extremely valuable skill, whether you’re an entrepreneur judging your company’s performance or an investor reviewing your portfolio.
Like all financial metrics, return on investment has its limitations. However, when used the right way, it’s one of the most useful metrics available for measuring the overall performance of your investments.