Return on investment (ROI) refers to a metric that measures profit or loss generated by an investment in relation to the invested funds and is expressed as a percentage. As the most common profitability metric, it helps to evaluate the performance of a company relative to the invested money.
It’s important to understand that profit is different from Return on Investment. Why? Profit refers to a metric that helps to determine the performance of a business while ROI is a profitability measure that helps to evaluate the performance of investments.
As a popular metric, it is preferred for being simple and versatile. It is easy to calculate because all you need is to determine gains attained from an investment and the cost of investment.
Here is the return on investment formula:
ROI = (Gain from an investment – Cost of an investment)/Cost of Investment X 100
Gain from an investment – this are the proceeds gained from the sale of an investment
Cost of an investment –the amount invested
(Gain from an investment – Cost of an investment) gives you Net profit gained by the business.
How ROI Works
As said earlier, ROI is simple and versatile which means it can be manipulated and interpreted easily. The formula can be used by a company to compare different investments while an investor can use the formula to determine the returns on a stock. To better understand how ROI formula is used, here is a real world example.
Let’s assume we have an investor called Sam. The investor decides to purchase stock worth $20,000 belonging to Company A. After two years, he decides to sell Company A shares for $30,000.
To calculate ROI, Sam has to identify the relevant metrics. In our example above, gain from the investment would be $30,000 while the cost of investment would be $20,000.
To calculate ROI, Sam will determine net profit ($30,000 – $20,000) = $10,000. He will proceed to divide net profit by cost of investment {(10,000/20,000) X100} which means ROI will be 50%.
If Sam had other investments, he would use the same tactic and compare which of his investments have better gains and which do not.
Benefits of ROI
a. Measures profitability of an investment
As said earlier, ROI is a profitability measure that helps investors and companies to evaluate the performance of their investments. Thanks to ROI, investors can be able to know if the assets they acquired are providing the required gains and if they are worth keeping around.
b. Enables comparative analysis
Investors and companies usually diverse their interests which means they don’t invest all their funds in one company or a single investment. For example, you may find an investor with interests in Company A, B, C and more. Thanks to ROI, an investor can make a comparative analysis of the investments and determine the rate of return.
c. Helps to determine the performance of an investment division
The investment division of a company focuses on earning maximum profit plus making the right decisions when it comes to acquiring controlling stakes in other companies. ROI helps to measure the performance of the investment division by determining if investments made are profitable or not.
Final Thoughts
ROI is an important metric for any investor or investment company. Why? It helps to determine the profitability of investments. As a result, an investor or company can be able to determine if an investment is worth investing in or it can be sold off to recover the cost of investment and mitigate losses.