Return on Investment (ROI) is a metric used to assess how profitable an investment is. Calculating the figure helps evaluate an investment’s performance and lets investors make an effective comparison between investment options to check which one is the most efficient. Show
 You are free to use this image on your website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked The ROI allows individuals and businesses to observe the earnings from an investment against the expenditure on that investment. It is a financial ratio that lets businesses examine their position, depending on the returns their investments are likely to bear or have borne. Table of Contents
Key Takeaways
Return on Investment ExplainedReturn on investment signifies the profits made and the losses incurred on a particular investment. With the help of the obtained ROI, businesses and individuals get a chance to crosscheck their portfolios to understand which investments worked well for them and which have proven to be the wrong option. ROIs intend to help investors learn how fruitful their investments have been. This allows them to assess their investment portfolio and be wise enough to make future investment decisions. In addition, they also let businesses validate their other expenses, which they make to achieve their business goals and objectives. For example, if the profits garnered or losses incurred from investing in stocks is the ROI that helps individuals know where to invest the next time, the cost of advertising that helps generate leads and convert them into customers also acts as an investment. In the latter case, the number of leads generated and finally converted into consumers becomes the return on the investment made in advertising. In short, ROIs do not necessarily have a direct monetary value. TypesROI can be calculated using different methods. Depending on the versions used for calculation, it is classified as – Net Income ROI, Capital Gain ROI, Total Return, and Annualized Return. You are free to use this image on your website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked #1 – Net Income MethodROI formula = (Net Income / Investment cost) * 100 #2 – Capital Gain MethodROI Formula = (Current Share Price – Original Share Price) * 100 / Original Share Price #3 – Total Return MethodROI Formula = (Current Share Price + Total Dividends Received – Original Share Price) * 100 /Original Share Price #4 – Annualized ROI MethodROI Formula = [(Ending value / Beginning value) ^ (1 / no. of years)] – 1 ROI FormulaThe formula used in company analysis to calculate return on investment is: Calculation ExampleLet us understand the return on investment meaning better using the following example: Suppose an investor invested $1000 in the bakery in 2020 and sold his stock in 2021 at $1200. The above formula helps calculate the ROI in this case:
Next, he also invested $2000 in the shoe business in 2020 and sold his stock in 2021 at $2800. So, the same formula lets calculate the ROI here:
This is how the ROI allows one to identify the best investment option available. The above example makes clear that investors can book more profit in the Shoe business as the ROI is higher than that of the bakery business. Advantages & DisadvantagesWhile the highest or best return on investment indicates a better investment portfolio or efficient business, the poor ratio allows individuals and businesses to identify areas where they should not invest or spend. Though ROIs help to make better decisions, they are not a flawless approach. Here is a list of advantages and disadvantages that one must know of: ProsConsSimple calculationManipulation risk existsEasy to read and understandIndependent of the time factorHelps compare the efficiency of firms and investments A common method of calculating returns Enables effective decision-makingReturn on Investment vs Return on Invested Capital vs Return on EquityReturns can be calculated based on different parameters, which make them be called differently. Some such terms include return on investment (ROI), return on investment capital (ROIC), and return on equity (ROE). Though these terms signify the types of returns, the motive behind calculating them is different.
Frequently Asked Questions (FAQs)What return on investment is good? If the return is 7 percent or more, it is considered a good and considerable ROI. Though the value may be higher in some years and poor in a few, having at least 7% ROI indicates consistency and stability in a business firm or individual investment portfolio. What debenture holders receive as a return on investment? While shareholders receive dividends as their ROI, debenture holders receive interest as the return on their investment. The latter’s return is received irrespective of whether the company reaps profits or not. With the help of debentures, investors receive a regular interest or coupon rate. In addition, the convertible debentures turn into equity shares at maturity. This makes the deal even more attractive to investors. Plus, debenture holders are preferred over common stockholders of the company when it comes to paying returns in the event of bankruptcy. Where do shareholders’ return on investment come from? The shareholders’ ROIs come in the form of a dividend, a portion of the profits a company in which they invest makes. Another way in which they receive their returns is through capital growth. This means as the firm’s performance improves, the share value increases. As a result, the shares owned by those shareholders become more valuable with time. Recommended ArticlesThis article has been a guide to what is Return on Investment. We explain its types, advantages, disadvantages, and formula with a calculation example, vs ROIC & ROE. You may learn more about Financial Analysis from the following articles –
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