Return On Investment (ROI)
Return on investment often appearing under its acronym R.O.I. and which can translate into return on investment, rate of profit or rate of return.
Definition
It is a financial indicator that measures a ratio by comparing the amount of money invested in a project versus the amount earned. The whole is most often expressed as a percentage. This ratio therefore represents the profit made by an investor in his investment. It is a comparison between profits and invested capital, the higher the ratio, the more profitable the investment. This measure is used by investors to decide on the most attractive projects and can also serve as a marketing tool.
Details
This calculation, while it appears simple, does not always take into account all the necessary data and additional elements must sometimes be considered, such as the inflation rate for long-term projects where the non-material benefits of an investment, such as improving the perception of a brand image. It may therefore be useful to keep these factors in mind when calculating the R.O.I.
The limits of ROI
Calculating the ROI is part of the usual procedures when considering any investment, both in terms of forecasting and, later, monitoring and control. This indicator is quickly calculated and also promotes comparisons. However, the relevance of ROI is limited when it comes to measuring financial impact. In addition to this fragmented approach, there are often more global repercussions, which the ROI cannot anticipate. By analyzing the overall results of a company or by evaluating one-off investments, it is possible to identify certain weak points.
The ROI is an accounting indicator which in principle makes it possible to evaluate decisions taken in the past. ROI is not as relevant if you want to assess future investment projects.
The risks associated with the investments and the external influencing factors are not taken into account by the ROI. This is particularly the case for the economy, possible economic crises, customer satisfaction, competition, etc.
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Since ROI is an indicator calculated on the basis of a fixed period, it is difficult to compare investments with different amortization periods. In practice, it is not always possible to attribute a company’s turnover and profits with certainty to specific investments.
Questions and Answers about Return On Investment (ROI)
1. Cindy purchased a house at the courthouse auction for $75,000 and spent $35,000 in renovations. After sales, expenses, and commission, you netted $160,000 on the sale of the renovated house. What is the ROI?
Answer:
Cindy’s net profit is going to be what you netted ($160,000) minus what you spent ($75,000 + $35,000), so it is $50,000. Anne’s total investment is also what you spent ($75,000 + $35,000), which is $110,000.
ROI = Net Profit / Total Investment * 100
ROI = 50,000 / 110,000 * 100
ROI = .45 * 100
ROI = 45%
If only house flipping was that easy. Keep in mind that Cindy can certainly lose money on an investment. If there is a loss, the formula will yield a negative number. Here’s a simple example:
ROI = -1,000 / 5,000 * 100
ROI = -0.2 * 100
ROI = -20%
2. If an investment costs $ 10 000 and which yields a gain of $ 15,000, what is the ROI % ?
Answer:
For an investment the cost of which is $10,000 and which yields a gain of $15,000, the ROI is equal to (15,000 – 10,000) / 10,000 or 50%.
3. A veterinarian intends to open his own clinic. The purchase of the equipment and the various investments required are valued at $100,000. Subsequently, the project brings in $150,000 over a reference period. Calculate ROI on every $1 invested…
Answer:
In such a case, the return on investment is 50% ((150,000 – 100,000) / 100,000) x 100, ie $ 1.5 earned for $ 1 initially invested.
4. John invested $90 into a business venture and spent an additional $10 researching the venture. The investor’s total cost would be a total of $100. If that venture generated $300 in revenue but had $100 in personnel and regulatory costs, then the net profits would be $200. Calculate the % of the ROI!
Answer:
As an example, take a person who invested $90 into a business venture and spent an additional $10 researching the venture. The investor’s total cost would be $100. If that venture generated $300 in revenue but had $100 in personnel and regulatory costs, then the net profits would be $200.
Using the formula above, ROI would be $200 divided by $100 for a quotient, or answer, of 2. Because ROI is most often expressed as a percentage, the quotient should be converted to a percentage by multiplying it by 100. Therefore, this particular investment’s ROI is 2 multiplied by 100, or 200%.
5. An entrepreneur has the choice between two projects:
Project 1, which is very risky, requires an investment of $ 200,000 and will generate an estimated final profit of $ 270,000. By applying the previously mentioned formula ((270,000 – 200,000) / 200,000) x 100, the return on investment is 35%.
Project 2, much less risky, also requires an investment of $200,000 and generates a profit of $265,000, i.e. a return on investment of 32.5% ((265,000 – 200,000) / 200,000) x 100.
Return on investment: definition, formula and concrete illustrations We can therefore see that the return on investment formula results in favoring the first project to the detriment of the second, while taking risks into account amounts to considering the second project as much more favorable ( slightly lower profitability, but much lower risk).
Answer:
Illustration n° 2:
For year n, an investor finances a project up to $ 100,000. In n + 8, the project generated $ 110,000 in profits. The return on investment is therefore 10%.
However, if we consider that inflation was 2% each year (17.16% over 8 years), we see that in the end, the project was not profitable, contrary to the result given by the formula Calculation. The figures must therefore be updated for long-term projects.
Another disadvantage of the return on investment lies in the fact that it only takes into account the economic aspect of the project while the latter can be profitable in other areas (improvement of the image of the company with consumers, for example).
6. Paul purchases property in Thailand, which is valued at $500,000. Two years later, Paul sells the property for $1,000,000. Calculate the % of his ROI!
Answer:
You should use the investment gain formula in this case.
ROI = (1,000,000 – 500,000) / (500,000) = 1 or 100%
7. If John decides to buy 1,000 shares of stock for $10 each, and then sell them a year later for $12 per share, John makes $12 for every $10 John spends, or $1.20 for every $1. Calculate return on investment or ROI John!
Answer:
In this case, John’s return on investment is 20%, because John returns John’s initial investment plus an additional 20%.
We can calculate John’s ROI using the following formula:
((net investment return) – (investment fee)) / (investment fee) x 100
So $12,000 Return on Investment, minus $10,000 investment cost = $2,000.
Then divide this by the investment cost ($10,000) and you get 0.2.
Finally, multiply this by 100 and John gets 20% as his overall ROI.
8. Betty decided to launch a digital marketing campaign to coincide with the launch of a new product. You choose Google pay-per-click as your primary marketing channel and commit to a budget of $5,000 per month.
After running this for 3 months, you review the sales and find that you have earned 7,000, thanks to the PPC (Pay per Click) campaign. If Betty’s product costs $10 with a 50% margin, then you’ve made $5 for each sale, or a total profit of $30,000 on the sale. What is Betty’s ROI? YES : ROI is also used to find out how wisely you invest in stocks.
Answer:
To find out Betty’s Return on Investment, simply subtract your marketing costs from the profits you make. In this example, it’s easy.
$30,000 – $15,000 = $15,000
Congratulations, Betty doubled your investment!
That’s a $2 return for every $1 spent or an overall 100% Return on Investment.
How to calculate the return on investment?
Formula Return On Investment (ROI)
ROI = Net Income / Cost of Investment
or
ROI = Investment Gain / Investment Base
or
ROI = Profit after tax / Cost of Investment x 100
Example calculation of R.O.I.
The calculation of the R.O.I. is simple: (positive or negative gain of the investment – cost of the investment) / cost of the investment. An example: for an investment of 5,000 €, the gain is 7,500 €. (7,500 – 5,000) / 5,000 = 0.5. The king. is therefore 50%. This is generally calculated over an annual period, hence the expression annual rate of return.
The following formula makes it very easy to calculate the percentage return on investment:
Return on investment (%) =
(investment gain – investment cost) / investment cost.
Please note, the method of calculating the return on investment does not take into account the risk of each project. A significantly higher ROI on a project can also hide a much higher risk rate. It will therefore be up to the investor to make a trade-off between potential profitability and the risk incurred.
In the case of long-term investments, it may be useful to use a discounting cash flow coefficient (€ 1 in 2010 will not have the same value as in 2100). There is a more precise (and complex) method in finance called: Net Present Value.
Be careful, if the ROI is positive, you can conclude that you have made a profitable investment.
Also your accountant is your best ally to manage your daily activity. We therefore advise you to call on their expertise to support you in monitoring your financial indicators. It has the performance keys you need.
Calculating your return on investment is therefore very important in order to define the overarching objectives of the company. The time spent calculating your capital budget and measuring the investment is crucial.
Annualized ROI Formula
As mentioned above, one of the drawbacks of the traditional return on investment metric is that it doesn’t take into account time periods. For example, a return of 25% over 5 years is expressed the same as a return of 25% over 5 days. But obviously, a return of 25% in 5 days is much better than 5 years!
If it happens, we can calculate an annualized ROI formula.
Annualized ROI Formula:
= [(Ending Value / Beginning Value) ^ (1 / # of Years)] – 1
Where:
# of years = (Ending date – Starting Date) / 365
Example of Annualized ROI Formula
For example, an investor buys a stock on January 1st, 2017 for $12.50 and sells it on August 24, 2017, for $15.20. What is the regular and annualized return on investment?
Regular = ($15.20 – $12.50) / $12.50 = 21.6%
Annualized = [($15.20 / $12.50) ^ (1 / ((Aug 24 – Jan 1)/365) )] -1 = 35.5%
Sources: Forbes, PinterPandai, Corporate Finance Institute
Photo credit: Tumisu via Pixabay
