ROI or return on investment is a metric that people use to know the profitability of an investment. To explain ROI in simple terms would mean that the metric compares how much you paid for investment with how much you earned. This helps to evaluate the efficiency of the investment. So, let’s see What ROI Means in Layman’s Terms and how it is used by individual investors and businesses alike
What is Return On Investment?
When an individual puts money into an investment scheme, the return on that investment lets you know how much profit or loss your investment has earned. The return on investment is a simple ratio that divides a profit or loss by the cost of an investment.
An ROI is always presented as a percentage. Hence, it becomes quite easy to compare the effectiveness of different investment options. Return on investment is quite similar to return on assets (ROA) or return on equity (ROE).
How to Calculate ROI?
One needs to divide the amount you earned from investment known as net profit, or cost of the investment minus its present value, by the cost of the investment and multiply it by 100. The result must be represented in percentage form.
Two ways to represent the formula are:
- ROI- (Net Profit/ Cost of Investment) x 100ROI-= (Present Value-Cost of Investment / Cost of Investment) x 100
So, if you invested $5,000 in an enterprise a year back, and sold your shares for $5,500, then this is how you would explain ROI to yourself.
ROI= ($5,500-$5,000/ $5,000) x 100
As a result, the return on your investment would be precisely 10%. One must exclude factors such as capital gain taxes or investment fees involved with buying or selling shares. However, one would need to factor those in for practical purposes.
The percentage figure one arrives at through the calculation is ROI’s superpower. So, one can leave aside the dollar amount and use the percentage to compare the return on investment of various investments across asset classes or currencies. It will help you determine which investment yields the highest ROI.
How Can an Investor Use ROI?
Regular investors use ROI to evaluate their portfolios. A business owner could use ROI to calculate his return on the cost of advertising. So, if the businessman spent $50,000 on his ad campaign and generated $750,000 in sales, the businessman received a 1,400% return on investment over the ad expenditure. In the same way, anyone who invests a certain sum of money to make a profit can use the ROI formula mentioned above to calculate his return percentage.
What is Good ROI?
Based on conventional standards, an annual ROI of 7% or more is considered a good return for investment in stocks. It is similar to the average annual return of the S&P 500, accounting for inflation. As it is an average, it will yield higher returns in some years and lower returns in others. However, the performance of your investment will smooth out to this percentage, over a sustained period.
One must bear in mind that just relying on an ROI percentage is not a very reliable way to analyze the performance of your investments. Various other factors influence your ROI and the S&P 500 may not be suitable for your risk appetite or the asset class you are investing in. Hence, one must ask themselves the following questions.
- What level of risk can I take?
- How will it affect me if I lose the money I am investing?
- How much profit do I need to make with a particular investment to endure the possibility of losing money?
- How can I put this money to better use if I choose not to invest it?
What are the Limitations of ROI
To explain ROI limitations, one needs to consider a few things. Firstly, return on investment never factors in time. So, if an investment had an ROI of 20% over 5 years while another had an ROI of 15% over 2 years, the simple ROI calculation cannot help you determine which investment was better. It is because ROI does not take into account compounding returns over time.
There are many basic principles of finance and accounting that are not required to effectively measure return on investment. Even though basic principles of finance and accounting may not be necessary to explain ROI, it helps to understand terms such as revenue, profit, loss, and cost. These will help you determine the direct costs saved or additional profits generated.
No, there is n need to understand high-level statistics as simple averages, variance, and standard deviation are all that are necessary to develop most ROI case studies. These concepts are very simple and can be easily implemented with a little bit of self-teaching and research.
Not at all. Calculating return on investment is one of the easiest aspects of investment. It is a very simple ratio of net profit or loss divided by the cost of investment. One needs to follow a simple step-by-step process with guiding principles mentioned before in the article, to collect data, and calculate benefits and costs.
Since the classic definition of return on investment is earnings divided by the cost of investment, it does not matter where the formula is applied. When it comes to human resources, the earnings are the net benefit from the program (monetary benefits- costs), and the investment is the money spent on the actual program.