ROI: Return on Investment Meaning and Calculation Formulas

Ever wondered if a financial decision is truly worth it? This is where Return on Investment (ROI) comes in. ROI is a metric that helps you understand how much profit or loss you generate from an investment compared to its initial cost. Let's take a simple example to understand this. Imagine you invest ₹10,000 in a stock that rises to ₹12,000 after a year. Your ROI in this case would be 20%, indicating a positive return on your investment. (20% = (₹12,000 - ₹10,000) / ₹10,000 x 100%). Now, let's delve deeper into understanding ROI, its applications and how it’s connected to your financial well-being.

What Is Return on Investment or ROI?

It is important for the investor to get a clear understanding of what the term ROI means. Return on Investment (ROI) is an investment performance measure that calculates the effectiveness of an investment in terms of profitability. It simply explains the ratio of the total output you gain to the total input you put as money. This is because the ROI is calculated in percentage form, which enhances the comparison between the returns of different investments.

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Stock Market: Investors employ the rate of return (ROI) to compare the performance of different stocks in their portfolio.

Business Decisions: Organisations employ ROI to establish the worth of marketing strategies, new equipment, or staff training.

Personal Finance: Organisations can consider ROI when deciding whether to invest in further education or undertake home improvement projects.

How to Calculate ROI

Calculating ROI is a straightforward process. There are two return on investment formulas used, but they are based on the same principle.

This method focuses on the change in the investment's value. ROI = (Investment Gain / Investment Base) x 100% Investment gain is the difference between the final value of the investment and its initial cost. Investment base is the initial cost of the investment.

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2. Net Profit Method:

   This is the most common method. ROI = (Net Profit / Cost of Investment) x 100% Net profit is the total gain from the investment after subtracting any associated costs. Cost of investment is the initial amount of money put into the investment.

3. Investment Gain Method:

Example: Let's say you pay an annual premium of ₹20,000 for a life insurance policy. Calculating the ROI on life insurance is not straightforward as it provides a payout upon death, not a return on investment. However, you can assess the cost-effectiveness by comparing the premium amount with the expected death benefit payout.

How to Use ROI

ROI is a valuable tool for making informed investment decisions. A few ROI best practices are:

• Compare Investment Options: Use ROI to compare the potential returns of different investment options and choose the one that aligns with your financial goals and risk tolerance.
• Evaluate Project Performance: Businesses can utilise ROI to assess the effectiveness of various projects and allocate resources efficiently.
• Track Progress Over Time: Monitor ROI over time to identify trends and see if your investments meet your expectations.

What is a Good ROI?

There's no one-size-fits-all answer to what constitutes a "good" ROI. It depends on several factors.

First, good return on investment (ROI) is not the same for all types of investments. Thus, the expected ROI is not constant, depending on the type of investment. For instance, the return on investments that could be riskier, such as stocks, might be higher than the return on investment from less risky options, such as savings accounts.

It also has to do with what one can refer to as a good return on investment in relation to the time frame. However, the specific period you are willing to hold the investment may also have an impact. Short-term investments may also have low returns as compared to long-term investments. Suppose you are putting ₹10,000 in a fixed deposit at an interest rate of 5% per annum for a year to maturity. This translates to a potential ROI of 5% as seen in the above example. This might appear to give a low return on investment but could be suitable where the investment period is short, for instance, saving for a trip. On the other hand, if you are investing for a certain period of time such as for retirement, you may be interested in achieving a higher return on investment. For instance, the stock has been known to generate better average returns than the fixed deposits in the long run. However, they also have their drawbacks which are often worse than the previous ones.

Also, the risk-taking capacity of every person plays a part as well. Interests with a higher risk appetite may opt to have a low ROI in the hope of a higher return on their investment. Imagine two investors, Anjali and Bikram:

• Anjali is also highly cautious with risk, and her main financial strategy is to maintain her capital gain. She may be comfortable in getting a fixed deposit rate of return, which is 7% guaranteed however, the possibility of a greater rate of return is bound.
• Bikram is relatively ok with the risk of these investments that is, he is comfortable taking higher risks in order to reap higher returns. He might invest in stocks, which can achieve higher returns in the long run, with figures like 15% and more, but also to which one risks something.

Anjali's and Bikram's risk tolerances influence what they consider a "good" ROI. While a 7% ROI might seem good to Anjali, considering her risk profile, Bikram might target a higher ROI to justify the inherent risk associated with stocks.

How Do You Interpret ROI Calculations?

While ROI provides a valuable snapshot of an investment's performance, it's crucial to interpret it with caution. Here's why.

ROI calculations don't consider time. Time is important as many investments take time to see a return. An investment with a quicker return might be preferable even if the overall ROI is lower. ROI only looks at the return on investment, not the risk involved. A higher-risk investment might have a higher potential ROI, but this needs to be considered alongside the risk tolerance.

Importantly, some investments might have ongoing costs that aren't factored into the ROI calculation. Consider these additional costs when making investment decisions. For example, imagine you invest in a rental property. The ROI calculation might only consider the difference between the purchase price and the final selling price, along with any rental income earned. However, it wouldn't account for ongoing costs associated with the property, such as maintenance fees, property taxes, and insurance. These ongoing costs can eat into your overall returns, so it's crucial to factor them in when evaluating the ROI using a method like subtracting the total expected costs over the holding period from the net profit before calculating the ROI percentage. By considering these additional costs, you can get a more realistic picture of the investment's profitability.

Advantages of ROI

ROI offers several advantages. Firstly, ROI is a relatively easy-to-understand metric that helps compare diverse investment options. Let's say you're considering investing in two ULIP funds. Fund A has an ROI of 15% over the past year, while Fund B has an ROI of 10%. At a glance, ROI indicates that Fund A has potentially yielded a better return on investment.

Next, ROI provides a standardised way to measure the performance of various investments within a portfolio. Imagine you have a portfolio containing stocks, bonds, and real estate. By calculating the ROI for each asset class, you can gain insights into which ones are performing well and which might need adjustments.

Also, ROI serves as a helpful tool for making informed investment decisions by allowing you to compare potential returns and risks. For instance, you're contemplating a home renovation project that costs ₹500,000. You estimate the renovation could increase the value of your property by ₹700,000. Calculating the ROI using the net profit method (ROI = ((₹700,000 - ₹500,000) / ₹500,000) x 100%) would result in a 40% ROI. This ROI, alongside other factors like the renovation's purpose and your risk tolerance, can help you decide if the project is financially worthwhile.

Disadvantages of ROI

While beneficial, ROI has some limitations. For one, ROI doesn't account for the time value of money. A rupee today is worth more than a rupee tomorrow due to inflation. ROI might not accurately reflect the profitability of an investment held for a long period. Let's say you invest ₹10,000 and earn a 10% ROI after one year, resulting in a total return of ₹1,000. This translates to a final investment value of ₹11,000. However, inflation might have eroded the purchasing power of that ₹11,000 over that year. In simpler terms, what you could buy with ₹11,000 today might cost slightly more due to inflation. Therefore, ROI might not accurately reflect the profitability of an investment held for a long period, especially when inflation is a factor.

Two, ROI is a quantitative measure and doesn't consider qualitative factors like brand reputation or social impact, which might be important for certain investments. Let's take two companies as an example. Company A offers a new investment opportunity with a projected ROI of 15%. However, the company has a history of poor labour practices and environmental violations. Company B offers a similar investment with a slightly lower projected ROI of 12%. But, Company B is known for its commitment to ethical sourcing and social responsibility initiatives. Here, ROI alone wouldn't tell the whole story. If you prioritise supporting companies with strong social values, Company B might be a more attractive option despite the lower projected ROI.