This article explains Return On Investment or ROI in a practical way. After reading you will understand the basics of this powerful financial management tool.
What is Return on investment (ROI)? Introduction and definition
Running a business and making investments are inextricably linked with one another. Running a business includes making continuous (re)investments and taking acceptable risks the purpose of which is to generate turnover and making a profit.
One of the instruments that can be used in this is Return On Investment or ROI. Return On Investment or ROI is used to indicate the ratio between the return that is realized and the money that is invested.
Return on Investment (ROI) is one of the most widely used methods in calculating the profitability of investment opportunities. This KPI allows investors to decide whether or not an investment is worth the effort.
This handy tool is used by investors, analysts, and companies in general in making important decisions on both the short term and the long term. When used correctly the use of the ROI tool has the following benefits:
- It helps investors to check the prospects of an investment opportunity
- ROI helps with measuring potential returns on a variety of opportunities
- ROI helps measure the benefits of investing in certain departments within a company
- ROI helps measure market competition
- ROI is simple and very effective
- The calculations made with ROI are easy to understand and are expressed in financial ratios.
- ROI is accepted by many investors around the world as an effective method
Return on Investment (ROI) vs Internal Rate of Return (IRR)
There are various methods to measure investment performances, but there are only few that are as popular and use as ROI and Internal Rate of Return (IRR). ROI is more common than IRR. IRR, in comparison to ROI, is a bit more complex.
Another difference between ROI and IRR is that ROI shows the total growth of an investment, from start to finish. The IRR only identifies the annual growth percentage. Eventually the two numbers will meet, but are certainly not the same over longer periods of time.
Prior to the question whether an investment should be made and whether this investment is the right investment, some questions should be asked, but even then the outcome depends on the questions asked and their mutual importance or interrelationship.
Examples of possible questions:
- To what extent is the investment effective, and does the organization get value for money?
- What are the direct costs?
- What are the indirect costs?
- What are the possible opportunity costs, if any?
- To what extent is the investment efficient; can we get more and better things with the same money?
- Is the investment justified; does this yield enough profit for our target group (in the case of a company for instance the owners, shareholders; in the case of a government institution for instance the citizens, the government itself)?
Return On Investment formula
The return on investment or ROI formula is as follows:
ROI = (Revenue from investment – Cost of Investment) / Cost of Investment
The result is represented as a percentage.
Return on investment and ‘payback period‘ are often mixed up with each other in popular parlance.
There is some confusion because return on investment or ROI is sometimes referred to as ‘payback period‘. However, there is a significant difference.
Return on Investment (ROI) calculation example
Say an investor has bought 100 shares in the ABC-technology company. The shares cost him 10 euro each. A year later, he sells his shares for 12.50. Over the course of the year, the investor earned 500 euro in dividends. 125 euro were spent on trade commissions to buy and sell the shares. The Return on Investment (ROI) for this investment activity can be calculated as the following:
To calculate the net return, the total returns and the total costs need to be calculated. The total returns consist of surplus value and dividends. The total costs of the investments consist of the initial purchase price and paid commissions. In the example above, the gross value of commissions is (12.50-10.00) x 100 = 250 euro. The total dividends make up 500 euro, and 125 euro was spent on commissions.
The completely filled-in equation reads as followed:
ROI = ((12.50-10.00) * 100 + 500 – 125) / (10.00*100))
If the ROI is further dissected, it shows that 23.75% of the returns came from surplus value, and 5% from dividends. This is important because dividends and capital gains are taxed in different ways in most jurisdictions.
Return on investment or ROI versus payback period
The payback period of an investment indicates how long it takes before the cumulative sales (cumulative cash inflow) are higher than the cumulative expenses (cumulative outflow) that are linked to the investment.
It is a method of investment appraisal that is based on the liquidity of investments: the project with the shortest payback period (which therefore has the best liquidity) is rated the best.
Return on Investment (ROI) in real estate
The foundation for all investments is earning money. Without positive prospects on the possible returns, no investor will pull the trigger on making an investment. This is true for traditional shares, obligations, or investments in real estate.
The investors who can calculate their potential earnings most accurately will increase their chances of success. One of the best indicators investors use for this is ROI.
As explained, the ROI equation calculates the ratio between the potential profits and an investment’s associated costs. It measures exactly how much money can be earned with an investment. Investors use ROI to evaluate the profitability of their options.
ROI in the rented sector
One of the ways ROI is applied in real estate is calculating the ROI on rented homes. The return on investment actually represents the potential of income generating assets.
Investors who want a certain return from their investments, can check with ROI if that will be the case, and then whether or not they should make the investment. ROI is one of the best indicators to decide whether or not an investment option is worth the effort.
A high ROI suggests that the profits match up favourably against the costs of an investment.
ROI as a comparison method
Another purpose of ROI in real estate is comparing options. An investor needs to be able to compare countless investment opportunities. Not every house has the same potential, which means that the return on each house will be different.
A starting investor would do good by comparing as many options as possible in order to find the best option. ROI is also used to view the various options within a portfolio. Usually the option with the highest ROI will be prioritised.
Every advantage has its disadvantage
ROI can clearly identify the profitability of an organization or project. In this way, investments can easily be compared with one another. The profitability of a company is after all very important.
Although the return on investment or ROI is a prominent ratio in many annual reports, it also gives rise to some criticism. The objection is that the ratio is not very precise because it depends on a number of variables such as duration of projects, depreciation, payback period and organizational growth.
Drawbacks and pitfalls of Return on Investment (ROI) as a tool
Alongside the series of benefits of using ROI, there are (unfortunately) a number of drawbacks and pitfalls. The most important ones are listed below. Remember that not a single help tool for calculating potential return is perfect.
It is difficult to come to a single satisfying definition of profits and investments. Profit has a number of definitions: profits after interest and taxes, verifiable profits, profits after subtracting costs, etc. Additionally, the word investment has a number of definitions: gross carrying value, net carrying value, current costs of assets, assets including intangible assets, etc.
In comparing various investment options with ROI, it’s important that different companies apply the same or similar accounting principles and methods with regard to valuing stocks, fixed assets, division of overhead costs, etc.
Sensitive to interests
The Return on Investment (ROI) tool can help divisional managers make decisions on investments, for example. Herein lies the danger that the divisional manager will only select investments with high returns. Other investments that would lower the division’s ROI are rejected, but the options that could raise the value of the company as a whole are rejected.
Return on Investment (ROI) summary
The evaluation of investment options is an important part of work for many managers and other executives. A few tools are used for this, including the Return on Investment (ROI) ratio. ROI is one of the most common methods for calculating the returns on an investment. This KPI provides insight on investment opportunities, helps measure competition, is simple and very effective.
By using ROI, various questions can be answered, such as: How much are the direct and indirect costs? What are the alternative costs? Is the investment justified?
Real estate is an example of a sector where this tool is often used. A real estate dealer’s goal is to earn money. Without positive prospects on the possible returns, no investor will make an investment. With ROI, the profitability of an organisation or a project can be clearly assessed. This way, it becomes simpler to weigh different investments.
There are also a few drawbacks or pitfalls to using ROI as a help tool in making investments. It is important that organisations speak the same financial language. That means, applying the same methods and practices. Additionally, it occasionally occurs that divisional managers will only base their choices on good ROI, and not the overall health of a given business.
It’s Your Turn
What do you think? Is the Revenue on Investment formula applicable in today’s modern companies? Do you recognize the practical explanation or do you have more suggestions? What are your success factors for using a financial investment method?
Share your experience and knowledge in the comments box below.
- Leffingwell, D. (1997). Calculating your return on investment from more effective requirements management. American Programmer, 10(4), 13-16.
- Phillips, J. J. (Ed.). (1997). Measuring return on investment (Vol. 2). American Society for Training and Development.
- Phillips, P. P., & Phillips, J. J. (2007). Return on investment (pp. 823-846). John Wiley & Sons Inc.
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