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What is return on investment?
Return on investment (ROI), also called rate of return or yield, is a measure of the performance and efficiency of an investment. ROI is represented as a percentage of profit yielded by an amount of capital after costs and expenses over a certain period of time. Generally investors, bankers, and managers use ROI to compare the efficiency of several different investments.
Return on investment can be calculated several different ways:
ROI = gross profit – expenses / invested amount x 100
ROI = (gain from investment – cost of investment) / cost of investment x 100
ROI is not the same as profit or return on equity; they are related but distinct concepts. ROI is a comparative measure used to assess different investments. ROI helps observers compare the potential profit level available from investing in one company or asset versus another.
There are risks inherent in calculating ROI, as all of the variables in calculating ROI can be adjusted to suit a given situation or influence the outcome. All ROI calculations depend very closely on how expenses or costs are accounted for; adding in too much or excluding others has an outsized impact on the final ROI figure.
For a business, if the ROI of its activities is lower than the cost of capital to fund those activities, than investors would be better off pulling out their money and choosing a different investment. ROI is a key consideration for marketing and advertising budgets, helping companies understand how much return they derive from various levels of spending on marketing. Real-estate ROI calculations attempt to capture amortization and appreciation to determine the return on different real property investments.
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Return on investment example
Georgia accumulated a stock portfolio with a cost basis of $5,000, plus $400 in commissions, and sold them once the value of the shares reached $7,500. Georgia’s net profit was $2,500. To determine her return on investment, Georgia subtracts the commissions of $400 from the net profit of $2,500, and divides the resulting figure by the $5,000 cost of the investment, then multiplies this figure by 100, which results in an ROI of 42 percent. This compares very favorably to the 10 percent ROI that Georgia’s friend, Franz, offered on a potential real estate deal, so Georgia leaves her stock investment alone and turns down Franz’s offer.