Return on investment (ROI) is a performance metric needed to understand the net profit of any investment. Both investors and businesses use it to know how much profit or loss an investment brings in. Whether you want to evaluate the profitability of one particular investment or compare the efficiency of several different investments, ROI is your go-to method. Since the result is always expressed as a percentage, ROI is the perfect tool to compare and evaluate the effectiveness of different investment choices.
How to calculate ROI?
To calculate the ROI, divide the return of an investment (also known as the net profit) by the investment cost and multiply that by 100. There are many ways to calculate the ROI, but this is the most common method used. The final result is always expressed as a percentage. The formulas are represented as:
ROI = (Net Profit / Cost of Investment) x 100
ROI = (Present Value – Cost of Investment / Cost of Investment) x 100
For example, let’s say you invested 10000 rupees last year, in a certain company of your choice. You sold your shares for 11000 rupees this week. Simply use one of the formulas above to calculate your ROI:
ROI = (1,000 / 10,000) x 100
ROI = (11,000 - 10,000 / 10,000) x 100
The ROI on your investment in this particular company would be 10%. This percentage figure is ROI’s area of speciality. To choose the most beneficial investment, you have to take this percentage and compare it to the ROI percentage of other investments.
How to interpret ROI?
Due to its simplicity, ROI is a prevalent metric and can be used as an elementary indicator of an investment’s profitability. For maximum accuracy, total returns and total costs should be calculated correctly. ROI calculations with a positive percentage mean the investment or business is profitable. On the other hand, ROI calculations with a negative percentage suggest the investment or business is suffering a loss.
How to use ROI?
ROI can be used by pretty much anyone to assess their expenditure and returns. Regular investors can evaluate their investments as well as their portfolios by using ROI calculations. It is also used and applied by business owners to assess prior and future investments and assess the returns on estimates and budgets. For example, if you want to calculate the return on the cost of marketing or advertising, ROI will be a critical factor in determining the right choice. However, it is important to note, ROI is not capable of eliminating risks or uncertainties. Your ROI is determined by the numbers you feed into your calculation. It is entirely up to you to calculate and consider the chance that your projection of the net profit might be too hopeful or too bleak. As we all know, when it comes to investments, records of success in the past do not guarantee the same for the future.
What are the benefits of ROI?
The benefits of ROI percentages and calculations include the following:
- It is substantially easy to calculate and assess ROI percentages. All the figures required for the calculation should be readily available in your balance sheets or financial statements.
- It is used extensively for various assessments worldwide and completes calculations with ease. Therefore, when it comes to investment returns, more comparisons can be made between different organisations.
- It is most commonly used to measure profitability. ROI is associated with the net profit for investments made in a particular business unit. This provides the company or team with a better way to measure profitability.
What are the limitations of ROI?
At present, the most commonly used investment and profitability ratio are ROI. However, they also come with a few limitations as well. These include the following:
- ROI cannot take time as a factor into consideration. For example, let’s say investment x had an ROI of 15% over five years and investment y had an ROI of 10% over two years. Since ROI doesn’t take compounding returns into account, the basic calculation will not help you determine which one is the better investment option.
- Every business has its way of calculating the ROI, as there are different equations available. This makes the comparison between ROI calculations and investments between companies irrelevant.
- It is very easy to fall prey to investments with larger ROIs. Investments with lower ROIs can help you avoid risks while maintaining the value of your business. However, the ROI calculation alone does not help determine what kind of net profit you will gain. Investors should be vigilant, as negligent choices could lead to poor allocation of resources.
What are the alternatives to ROI?
There are alternative measurements to ROI that businesses use. These include the following:
- Annualised ROI is a form of ROI that considers the length of time as a factor while evaluating the potential returns of an investment. For example:
Annualised ROI = ((Final value of investment - Initial value of investment) / Initial value of investment) x 100.
- Social ROI (SROI) is a form of ROI that is based on outcomes. It contemplates the broader impact of environmental, economic, and social values. For example:
SROI = Net present value of benefits / Net present value of an investment.
- Social media statistics ROI is a form of ROI that helps evaluate the efficacy of a social media campaign. This also includes the number of views and likes that are generated. For example:
(Value / Total investment) x 100.
- Marketing statistics ROI is a form of ROI used to determine the effectiveness of a marketing plan or marketing campaign strategy. For example:
(Sales growth - Marketing cost) / Marketing cost.
ROI is a preferred metric choice that is easy to understand and calculate to determine the potential returns of an investment. It is widely used and helps you compare with other investment options based on their respective ROI percentages. However, ROI takes neither the risk factor nor the time factor into consideration. Hence, investors cannot use ROI as the only metric to make their final choice. If you’re just getting started with investments, evaluating your choices using ROI is a good option. But, make sure to explore other metrics as you go along.
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Q. What is a good ROI?
Ans. For investments, an annual ROI of approximately 7% and up is considered good. However, this is an average yearly return estimate as we also have to keep inflation in mind. Because of this, your returns may be higher some years and lower some years too. But, your overall return amount will pan out as per the calculations.
Q. Why should you calculate ROI?
Ans. One of the main advantages of calculating ROIs is the decrease in expenditure and increase in profit. To be aware of what adds value to your company whereas what does not, it is essential to calculate the potential return on all actions taken. This will allow you to eliminate any kind of investments that generate only expenses. Therefore, you can wisely reallocate your resources towards more suitable investments that will generate greater revenue.
Q. Do you have to know the statistics to understand ROI?
Ans. To understand ROI, you only have to know basic statistics, such as simple averages, variance, and standard deviation. Additional simple concepts like hypothesis testing and correlations might be necessary at times. This article covers all the essential statistics you may need while getting started with ROI.
Q. What types of applications are typical for ROI analysis?
Ans. Applications typical for ROI analysis usually include:
- Sales training
- Supervisory training
- Team building
- Leadership development
- Executive development
- Software utilisation
- Competency systems
- Orientation systems
- Reward systems
- Compensation and benefits
- Skill-based pay
- Career management
- Major projects
- Wellness initiatives.
Q. What are the standards for ROI?
Ans. The standards for ROI methodology is labelled as the “Guiding Principles.” These standards bring forth consistency for the analysis with a more conventional approach. This, in turn, builds credibility with the stakeholders.
Q. Who uses the ROI methodology?
Ans. ROI methodology is used globally by all kinds of businesses and organisations. This includes over 2000 private-sector organisations and around 200 government agencies and non-profit organisations. Apart from this, currently, 20,000 specialists and managers actively use and implement the ROI methodology.