Trading Education

The Simple Guide to Return on Investment (ROI)

Investments are a type of passive income that allows one to receive dividends only through the contribution. To optimize risks and get more income, a return on investment indicator is used. This value determines the ratio of risk to reward and makes it clear whether it is worth considering an option for investment. Any investor will agree that return on investment is a prerequisite for effective money management, without which it is impossible to achieve success and financial freedom. Profitability is only valuable if it is verifiable and predictable. In the theory and practice of investment, several coefficients and indices have been developed that can be used when planning and calculating investment results. 

What is the Return on Investment (ROI)?

Return on investment is the ratio of profit after deducting all payments and taxes to the cost of equity and long-term borrowed funds, that is, investment in activities.

Since the main purpose of investment is to make a profit, the profitability indicator is a key characteristic, with which one can decide on the necessity and expediency of investments. Most often in professional circles, to define this concept, they use the abbreviation ROI - return on investment or ROR - the rate of return, meaning the return on investment. Therefore, when meeting ROI in financial securities, an investor must clearly understand that this is an important indicator of return on invested capital.

ROI coefficient does not show a clear level of profitability, but only indicative figures, a forecast of potential profit. Despite this, its assessment will help determine whether it is worth investing in this project, or the return on capital investment in another direction will be better.

Based on its calculation, one can form an opinion about the possible acceptance or cancellation of several economic decisions:

  • Acquisition of an asset;
  • Feasibility of investing in the development and expansion of business (modernization, entering new markets);
  • The effectiveness of the advertising campaign (increase in sales);
  • Purchase of securities on the stock market;
  • Obtaining a bank loan for investment purposes.

How to Calculate ROI: Formula

To correctly interpret the calculation results and make the right decision, you need to understand the method for calculating the indicator. The following data are used for calculations:

  • Current value - cost at the time of calculation
  • Investment volume - investment amount
  • Income - total revenue
  • Cost - total costs

To obtain accurate results of values characterizing the return on investment, the data for the calculation are taken that are comparable and do not go beyond the relevant range.

Calculations of the ROI coefficient can be different, depending on the sphere and situation, types of income, and expenses. ROI seeks to show the approximate value of the return on investment, but since there are many areas and types of investments, there can be no single formula.

Several formulas can be used to calculate ROI. The simplest formula will be:

ROI = (current value - investment volume) / investment volume

For example, you bought an asset for $8000. You then hold it for two years. Suppose that the price went up on the market and you can now sell it for $20,000. According to the formula, the ROI will be 1,5.  If you multiply it by 100, you get the rate of return (ROR). This means that you made a 150% gain on your original investment.

The following method is used by investors in assessing the effectiveness of investments and by marketers of the organization to justify the effectiveness of marketing activities. 

ROI = (income - cost) / investment volume * 100%

*The format for calculating the coefficient is the percentage

To calculate the ROI, taking into account the duration of the period of ownership of the asset, the following formula is applied:

ROI = (income - cost) * period duration / investment volume * 100%

The method allows one to calculate the value of the return on investment if the asset was owned by the investor for an incomplete period more correctly. 

Calculations using these formulas can be carried out both for the asset as a whole (organization, portfolio of investments in securities), and for each specific transaction.

Pros and cons of ROI

The return on investment ratio forms an estimated opinion among potential investors about how the investment in this project is profitable. Besides, this coefficient makes it possible to:

  • Consider the time factor when assessing income;
  • Considers the sum of all investment income options, not just short-term profits;
  • Compare several projects to choose the best investment option;
  • Flexibly change the calculation formula to obtain the most informative indicator for a specific situation.

In addition to the visible advantages, like any other coefficients, it has disadvantages:

  • Single ROI cannot provide a comprehensive assessment of the effectiveness of a particular business or transaction. It is necessary to calculate other factors and their joint analysis;
  • The coefficient is static (calculated on a specific date) and does not take into account the time value of money.

Closing line

ROI is a great option for the express assessment of a business transaction. The flexibility of the calculation options allows it to be used in most cases. Just remember, don't use ROI calculations as the only source of data for making decisions. This indicator is fully disclosed only in conjunction with other coefficients of financial analysis. You also need to consider opportunity costs, risk-reward ratios, and other factors that can influence your choice between different investment opportunities.

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