What is ROI?
Return on investment, or ROI, is a mathematical formula that investors can use to evaluate their investments and judge how well a particular investment has performed compared to others. An ROI calculation is sometimes used with other approaches to develop a business case for a given proposal. The overall ROI for an enterprise is used as a way to grade how well a company is managed.
If an enterprise has immediate objectives, including getting market revenue share, building infrastructure or positioning itself for sale, a return on investment might be measured in terms of meeting one or more of these objectives rather than immediate profit or cost savings.
How do you calculate ROI?
There are multiple methods for calculating ROI. The most common is net income divided by the total cost of the investment, or ROI = Net income / Cost of investment x 100.
As an example, take a person who invested $90 into a business venture and spent an additional $10 researching the venture. The investor's total cost would be $100. If that venture generated $300 in revenue but had $100 in personnel and regulatory costs, then the net profits would be $200.
Using the formula above, ROI would be $200 divided by $100 for a quotient, or answer, of 2. Because ROI is most often expressed as a percentage, the quotient should be converted to a percentage by multiplying it by 100. Therefore, this particular investment's ROI is 2 multiplied by 100, or 200%.
Compare that to another example: An investor put $10,000 into a venture without incurring any fees or associated costs. The company's net profits were $15,000. The investor made $5,000. It is significantly more than the $200 in net profits generated in the first example. However, the ROI offers a different view: $15,000 divided by $10,000 equals 1.5. Multiplying that by 100 yields an ROI of 150%.
Although the first investment strategy produced fewer dollars, the higher ROI indicates a more productive investment.
Another possible method to calculate ROI is investment gain divided by investment base, or ROI = Investment gain / Investment base. There are numerous other ways to calculate ROI, so when discussing or comparing ROIs between departments or businesses, it is important to clarify which equation was used to determine the percentage. Each equation may measure a specific set of investments. ROI is shown as a percentage instead of a ratio for ease of understanding.
How do you interpret ROI calculations?
ROI can be used to gauge different metrics, all of which help determine how profitable a business is. To calculate ROI with the most accuracy, total returns and total costs should be measured.
When ROI calculations have a positive return percentage, this means the business -- or the ROI metric being measured -- is profitable. Meanwhile, if the calculation has a negative ROI percentage, that means the business -- or the metric it is being measured against -- owes more money than what is being earned. In short, if the percentage is positive, the returns exceed the total cost. If the percentage is negative, the investment is generating a loss.
What is ROI used for?
ROI can be used to evaluate various investment decisions, comparing them to their initial cost. Businesses also use ROI calculations when evaluating future or prior investments.
Individuals can calculate the ROI to judge their own personal investments and compare one investment -- whether it is a stock holding or a financial stake in a small company -- against another in their own investment portfolios.
What are examples of ROI calculations?
Calculating the investment figures for each piece of the ROI equation can sometimes get complicated for businesses.
For example, if a company wants to invest in deploying new computers, it must consider a variety of deployment costs. The business needs to consider the actual price of the computers, tax and shipping costs, consulting fees or support costs paid to purchase, plus setup and maintenance costs.
Then, the business would need to calculate net profit over a set period of time. These net profits could include hard dollar amounts coming from increased productivity and a reduction in maintenance costs compared to the previous computers.
That business could then calculate the ROI when evaluating two different types of computers using anticipated costs and projected gains to determine which ROI is higher. Therefore, which computer represents the better investment: Investment A or Investment B?
The business could also calculate the ROI at the end of the set time period using actual figures for the total net income and total cost of investment. Actual ROI can then be compared to the projected ROI to help evaluate whether the computer implementation met expectations.
What are the benefits of ROI?
Benefits of ROI ratios include the following:
- Generally easy to calculate. Few figures are needed to complete the calculation, all of which should be available in financial statements or balance sheets.
- Comparative analysis capability. Because of its widespread use and its ease of calculation, more comparisons can be made for investment returns between organizations.
- Measurement of profitability. ROI relates to net income for investments made in a specific business unit. This provides a better measure of profitability by company or team.
What are the limitations of ROI?
ROI is one of the most common investment and profitability ratios used today. However, it does have some drawbacks. These include the following:
- Inability to consider time in the equation. On the surface, the higher ROI seems like the better investment. But an investment that takes 10 years to produce a higher ROI pales in comparison to a second investment that takes just one year to produce a slightly lower ROI.
- ROI calculations can differ between businesses. Because there are different equations to calculate ROI, not every business uses the same one, making the comparison between investments irrelevant.
- Managers might only select investments with larger ROIs. Some investments with lower ROIs may still increase the value of a business. But suboptimal choices could lead to poor allocation of resources.
- No way to account for nonfinancial benefits. Using the ROI for new computers as an example, a business can use specific dollar amounts to calculate the net profit and total costs to come up with ROI. However, calculating the value of improved worker morale as a result of getting new computers is difficult. Businesses can, however, calculate ROIs for such nontangible benefits by labeling these calculations as soft ROIs, while the calculations made with tangible dollar amounts are called hard ROIs.
What are the alternatives to ROI?
There are similar alternative measurements to ROI that businesses use to varying degrees. These include the following:
- Annualized ROI. This form of ROI considers the length of time a stakeholder has the investment. Here is an example of an annualized return calculation: Annualized ROI = ((Final value of investment - Initial value of investment) / Initial value of investment) x 100. Likewise, the annual performance rate can be calculated using ((P + G) / P) ^ (1 / n) - 1, where P equals initial investment, G equals gains or losses, and n equals the number of years the investment is held.
- Social ROI (SROI). SROI is outcome-based and considers the broader impact of economic, environmental and social value. It translates these outcomes into tangible dollar values. The calculation is SROI = Net present value of benefits / Net present value of investment.
- Marketing statistics ROI. This helps determine the effectiveness of a marketing campaign strategy or marketing program. A basic calculation is (Sales growth - Marketing cost) / Marketing cost.
- Social media statistics ROI. This helps determine the effectiveness of a social media campaign and can include how many views or likes are generated. A simple calculation to measure the time, money and resources that went into social media ROI by revenue is (Value / Total investment) x 100.
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