What is ROI, and why do we use it?
Return on investment (ROI) is a profitability ratio commonly used in finance to calculate the return or profit an investment generates relative to its cost.
Expressed as a percentage, ROI is handy in evaluating the performance of assets or competing investment opportunities.
Put simply, ROI is a ratio between net profit and investment cost. A good ROI means the investment's gains compare favourably to its price.
The simplest form of the ROI calculation involves only two values: the investment's cost and the investment's gain. The ROI formula is as follows:
ROI (%) = Current investment value − initial investment value × 100% / initial investment value
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%
An ROI calculator divides the total value by total cost to determine the ROI percentage.
The ROI 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 use the ROI metric to compare her investment in Tip Top Transport with her other projects. 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%.
Jill's examples show that her investments had a positive ROI. If her investments lost money, this metric would be in the negative.
Investors can use ROI as a simple indicator of the profitability of invested capital. We can conduct return on investment analysis on current and potential investments or a business case. As ROI is measured in percentage terms, it is easy to compare the ROI of many different investments.
Are there limitations to ROI?
While generally helpful, there are some shortcomings to the ROI equation. Examples like Jill's reveal some limitations when weighing up performance over different periods.
In the above example, 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. A higher ROI is a less meaningful comparator when two investment figures are calculated over different periods of time.
For a better analysis, Jill could annualise the ROI of her second investment. The 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 overall, 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.
How to maximise your portfolio's ROI
Your aim as an investor is to maximise the ROI of your portfolio. But you can't control the inputs to the ROI metric. Share prices fluctuate over time, and no matter how much you believe in the shares you buy today, you can't predict what the share market will do in future.
There are, however, some steps you can take to try and maximise the ROI of your portfolio, which we have outlined here:
1. Invest consistently
This means making regular contributions when you can, whether in bear markets or bull markets. Although it can feel counterproductive to contribute to your portfolio when share prices are falling, you can buy more shares when they are selling at a lower price.
When the market picks up (as it inevitably does), you should make serious gains on those shares you picked up when the market was in the doldrums.
2. Diversify your portfolio
There is a reason seasoned investors talk about diversification – not only can it minimise risk, it can help to maximise ROI. Diversifying your portfolio means investing across different industries, companies, and even countries.
Think about it this way — if you only invest in one sector, say retail, you are totally exposed to the performance of that sector. If there is a market crash or correction, your portfolio could be crushed.
3. Keep your long-term goals in mind
Many investors dream of getting rich quickly. It can be tempting to engage in risky strategies to pursue this, which can ultimately backfire. Few investors will see a huge increase in their portfolio value in a short period of time.
Rather than trying to get rich quickly, focus on your longer-term financial goals and what you can do from day to day to build towards them. In investing, time can be your friend as it allows for returns to compound.
Developments in ROI
New types of ROI measurements have emerged over time. Traditional ROI measures the financial return of an investment. But 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 gives monetary value to specific environmental, social, and corporate 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.
While new niche forms of ROI may appear, some outcomes and impacts can't easily be measured with a monetary value. To calculate ROI, factors such as cash flow, net income generated by assets, and profit margin will have a significant effect. The ROI of invested capital will ultimately depend on the future cash flow it generates.