In business analysis, Return on Investment (ROI) and other cash flow measures—such as internal rate of return (IRR) and net present value (NPV)—are very key marketing metrics. Return on investment (ROI) is a simple and intuitive metric of the profitability of an investment. There are some limitations to this metric though.
However, despite these limitations, it’s still a key metric. Used by business analysts (like jmexclusives) to evaluate and rank investment alternatives. And the biggest benefit of ROI is that it is a relatively uncomplicated metric. Meaning, it is easy to calculate and intuitively easy to understand.
Additionally, ROI can also be used to evaluate the results of a real estate transaction. Making it relatively easy to calculate and understand. And its simplicity means that it is a standardized, universal measure of profitability.
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On the contrary, one of its disadvantages is that it doesn’t account for how long an investment is held. So, a profitability measure that incorporates the holding period may be more useful. Especially for an investor that wants to compare potential investments. So, what is it and how is it even calculated with examples?
What is the Return on Investment (ROI)?
Simply put, Return on Investment (ROI) is a financial metric that is widely used to measure the probability of gaining a return from an investment. It is a ratio that compares the gain or loss from an investment relative to its cost.
That’s why it’s as useful in evaluating the potential return from a stand-alone investment as it is in comparing returns from several investments. It’s totally unlike the Return On Marketing Investment (ROMI) — simply because both marketing styles are not of the same kind of investment.
So to speak, Return On Marketing Investment (in that case, ROMI) is the contribution to profit attributable to marketing (net of marketing spending). Then again, divided by the marketing ‘invested’ or risked.
The very simple calculation to figure out the return on investment, or, in short, “ROI”, can be very powerful in regards to acting as a flashlight in the dark. Meaning, are you making good or bad decisions. Perhaps your decisions could be better?
How the Return on Investment (ROI) is Calculated
ROI is calculated by subtracting the initial value of the investment from the final value of the investment (which equals the net return). Then dividing this new number (the net return) by the cost of the investment. And, finally, multiplying it by 100.
It’s important to realize, there’re a few things that you should consider when interpreting Return on Investment calculations. First, ROI is typically expressed as a percentage because it is intuitively easier to understand (as opposed to when expressed as a ratio).
Secondly, the calculation includes the net return in the numerator because returns from an investment can be either positive or negative. When the calculations yield a positive figure, it means that net returns are in the black—because total returns exceed total costs.
Alternatively, when these calculations yield a negative figure, it means that net returns are in the red—because total costs exceed total returns. And that’s why the investment in red is said to produce a loss. In summary, it can be calculated using two different methods.
Consider the following:
To calculate ROI with the highest degree of accuracy, total returns, and total costs should be considered. And, therefore, for an apples-to-apples comparison between competing investments, annualized ROI should be considered.
Example of Return on Investment (ROI)
Let’s assume an investor bought 1,000 shares of the hypothetical company Worldwide Wicket Co. at $10 per share. One year later, the investor sold the shares for $12.50. The investor earned dividends of $500 over the one-year holding period.
Again, the investor also spent a total of $125 on trading commissions in order to buy and sell the shares. In this case, the ROI for this investor can be calculated as follows:
ROI = ([($12.50 – $10.00) * 1000 + $500 – $125] ÷ ($10.00 * 1000)) * 100 = 28.75%
Please note that in order to calculate net returns, total returns and total costs must be considered. Total returns for a stock result from capital gains and dividends. Total costs would include the initial purchase price as well as any commissions paid.
Perspectively, in the above calculation, the gross capital gain (before commissions) from this trade is ($12.50 – $10.00) x 1,000. The $500 amount refers to the dividends received by holding the stock. While $125 is the total commissions paid.
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If you further dissect the ROI into its component parts, it is revealed that 23.75% came from capital gains and 5% came from dividends. This distinction is important because capital gains and dividends are taxed at different rates in most jurisdictions. Herewith, ROI = Gross Capital Gains % – Commission % + Dividend Yield.
And we can simply calculate it this way:
- Gross Capital Gains = $2500 ÷ $10,000 * 100 = 25.00%
- Commissions = $125 ÷ $10,000 * 100 = 1.25%
- Dividend Yield = $500 ÷ $10,000 * 100 = 5.00%
- ROI = 25.00% – 1.25% + 5.00% = 28.75%
Please Note: A positive ROI means that net returns are positive — because total returns are greater than any associated costs. While a negative ROI indicates that net returns are negative— because total costs are greater than returns.
The Alternative Method of Calculating ROI
If, for example, commissions were split, there is an alternative method of calculating this hypothetical investor’s ROI for their Worldwide Wicket Co. investment. Assume the following split in the total commissions: $50 when buying the shares and $75 when selling the shares.
- IVI = $10,000 + $50 = $10,050
- FVI = $12,500 + $500 – $75 = $12,925
- ROI = [($12,925 – $10,050) ÷ $10,000] * 100 = 28.75%
In this formula, IVI refers to the initial value of the investment (or the cost of the investment). While FVI refers to the final value of the investment. Equally important, the annualized ROI calculation provides a solution for one of the key limitations of the basic ROI calculation.
The alternative formula for calculating annualized ROI is as follows:
Annualized ROI=[(1+ROI)1/n−1]×100% — where: n = Number of years for which the investment is held.
The Limitations of Return on Investment (ROI)
Its simplicity means that it is often used as a standard, universal measure of profitability. And as a measurement, it is not likely to be misunderstood or misinterpreted. Because it has the same connotations in every context. But, there are also some disadvantages of the ROI measurement.
First, it does not take into account the holding period of an investment. Above all, which can be an issue when comparing investment alternatives. Second, it does not adjust for risk.
It is common knowledge that investment returns have a direct correlation with risk—the higher the potential returns, the greater the possible risk. Third, ROI figures can be exaggerated if all the expected costs are not included in the calculation. This can happen either deliberately or inadvertently.
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These expenses can subtract a large amount from the expected ROI. And without including all of them in the calculation, the figures can be grossly overstated. And like many profitability metrics, it only emphasizes financial gains when considering the returns on investment.
It does not consider ancillary benefits. Such as social or environmental goods. A relatively new ROI metric, known as Social Return on Investment (SROI), helps to quantify some of these benefits for investors. With that said, if you’ll need more support on this topic, feel free to Contact Us and let us know how we can help you.
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