Return on investment (ROI) is a financial ratio between net profit and cost of investment that describes the efficiency of an investment.
As a simple method, ROI is mainly used at the initial stage of analysing the profitability of a project. It is used to compare company’s profitability and to compare the profitability of different investments. Usually, investments with higher ROI are more favourable.
ROI, in contrast to ROE (return on equity), takes into account total investment expenditure, i.e. both owner’s and shareholders’ equity.
How to calculate return on investment
Return on investment is calculated by dividing net profit by cost of investment. Net profit is the difference between the gain and the expenses of the investment. In other words, it’s the difference between gross profit and costs. ROI is expressed as a percentage, so the result of division should be multiplied by 100.
ROI = \frac{NP}{C} \times 100Where NP = net profit, and C is cost of investment.
To work out the net profit of an investment, you can subtract the cost of the investment from the gain made.
Return on investment explained
Simply speaking, the higher the ROI value, the better. As a rule, investors will choose an investment that has higher ROI than the industry / benchmark or other investments between which they choose. Therefore, simplified decision-making process looks like:
- ROIinvestment > ROI benchmark → the investment is acceptable (profitable)
- ROI investment < ROI benchmark → the investment is unacceptable (not profitable)
Return on investment can also be compared to WACC (weighted average cost of capital). WACC is a rate that informs about the average weighted cost of capital involved in financing the investment. WACC takes into account the weighted cost of different sources of capital: debt, stocks, options, liabilities, subsidies, etc.
- ROI ≥ WACC → the investment is acceptable (profitable)
- ROI < WACC → the investment is unacceptable (not profitable)
ROI value also shows how much profit is generated by each unit of money invested in the project. For example, ROI = 15% means that every dollar of invested capital generates 15 cents of net profit.
Advantages and disadvantages of ROI formula
Advantages of ROI
- does not require complicated calculations,
- intuitive,
- gives an opportunity to compare returns of various investments (as well as companies’ profitability),
- gives an insight into the effectiveness of company’s finance management
- the result is easy to interpret.
Disadvantages of ROI
- doesn’t take into account
- time value of money,
- risks of investments,
- company’s market value,
- time horizon of investments,
- the reasons of a certain ROI value, that’s why the investors can’t estimate whether these reasons will affect company’s profit in future,
- non-objective determination of acceptable rate of return.
Return on investment examples
Example 1
- An investor buys 100 stocks.
- The price per stock is $14 for a total cost of $1,400
- After a year the investor sells these stocks for $2,100.
Return on investment is 50%. That means that every $1 of invested money generated $0.50 of profit within a year.
Example 2
- An investor chooses between two investments.
- Investment A costs $1.000 and expected net profit is $300.
- Investment B costs $1.800 and expected net profit is $360.
- Both of these investments have the same risk.
Although the net profit of investment B is $60 higher than the profit of investment A, by calculating ROI an investor can indicate that return on investment A is 30% and return on investment B is only 20%. That means investment A is more favourable in this case, despite the fact, that net profit of investment B is higher.