What is return on investment (ROI)?
In this article, we take a closer look at return on investment (ROI) – what it is, how to calculate and understand it, and new developments impacting ROI for the future.
Return on investment (ROI) is a commonly used profitability ratio that calculates the return or profit an investment generates relative to its cost. Expressed as a percentage, ROI is handy in evaluating individual investments or competing investment opportunities.
Put simply, ROI is a ratio between net profit and investment cost. A high ROI means the investment’s gains compare favourably to its price.
How to calculate ROI
The simplest form of the ROI calculation involves only two values: the investment's cost and the investment's gain. The formula is as follows:
ROI (%) = Current investment value − initial investment value × 100% / cost of investment
The ratio is multiplied by 100 to make it a percentage. This way, you can see what percentage of investment has been gained back after a period of time.
The current investment value is simply the revenue from the sale of the investment. For example, an investor purchases property A, valued at $500,000. A year later, the investor sells the property for $700,000.
So, the ROI formula in this case would be:
ROI = ($700,000 – $500,000) x 100 / ($500,000) = 40%
The calculation is relatively easy to interpret for a range of ventures and investments.
For example, suppose Jill invested $1,000 in Tip Top Transport Corp in 2020 and sold her shares for $1,200 after one year. To calculate the return on her investment, she would divide her profits ($1,200 – $1,000 = $200) by the investment cost ($1,000), for an ROI of $200/$1,000, or 20%.
Jill could compare her investment in Tip Top Transport with her other projects with this information. Perhaps Jill also invested $2,000 in Big-Save Stores Inc in 2018 and sold her shares for $2,800 in 2021. The ROI on Jill’s holdings in Big-Save would be $800/$2,000, or 40%.
From Jill’s examples, we can see her investments had a positive ROI. If her investments lost money, the ROI would be in the negative.
Investors can use ROI as a simple indicator of an investment’s profitability. This could be the ROI on a share investment, the ROI a company expects on a factory expansion or the ROI generated in a real estate transaction. As ROI is measured in percentage terms, it is easy to compare the ROI of many different investments.
Limitations of ROI
While generally helpful, there are some shortcomings to the formula. Examples like Jill’s above reveal some ROI limitations, especially when weighing up the performance of investments.
In the above example, you can see the ROI of Jill’s second investment is double her first investment, but the time between purchase and sale is one year for her first investment and three years for her second.
For a better analysis, Jill could adjust the ROI of her longer investment. Her total ROI is 40%, so she could divide this by three to calculate an annual average ROI of 13.33%. With this adjustment, you can see that while Jill’s second investment earned more profit, her first investment was more efficient.
Additionally, the simplest form of ROI merely calculates the difference in the asset’s value over time. When investing in any asset, you also have to account for the costs of the investment, plus the tax implications, to get an accurate picture of your investment returns.
Developments in ROI
As it becomes essential for organisations to look at social and environmental impacts, a new way of measuring ROI has arisen. It’s called the ‘social return on investment’ or SROI.
SROI has emerged globally to give monetary value to specific environmental, social, and governance (ESG) criteria used in socially responsible investing (SRI). For instance, a company may replace its office lighting with LED bulbs or implement wastewater recycling in its factories. These expenses have an immediate cost which may negatively impact traditional ROI. However, the net benefit to society and the environment could lead to a positive SROI.
New developments in social media statistics pinpoint the effectiveness of a social media campaign. For example, how many clicks or likes are generated for a unit of effort. Also, ‘learning ROI’ shows the amount of information learned and retained as a return on education or skills training.
While many niche forms of ROI may appear, some outcomes and impacts (for example, improved relationships and increased self-esteem) can’t be easily measured with a monetary value. SROI analysis is an evolving area, and as such, more methods of monetising outcomes may become available.
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