In today’s dynamic market scenario, investors must always keep a close watch on their investments. One of the ways to check on the periodic investment performance is to look at the investment’s return or simply the return on investment (ROI). This is especially applicable to investments that are easily influenced by changing market scenarios, such as mutual funds, stock market investments, etc.
Among the different performance metrics that can be used to check an investment’s health, Return on Investment or ROI is considered one of the most useful and easy to calculate. Let’s understand the concept of ROI in detail.
What is return on investment?
When an individual investor makes an investment or an organization enters into a business endeavor, ROI helps them in understanding how much profit or loss has been made from the same.
Return on investment (ROI) is:
- a metric that helps investors know the profitability of their investment.
- a calculation that compares the amount paid towards an investment against how much earnings were made from the investment.
- helpful in evaluating the efficiency of the investment.
- related to other metrics, such as return on assets (ROA) and return on equity (ROE).
How do you calculate ROI?
Return on investment can be obtained by dividing the net profit or loss from an investment with the cost of investment. It is expressed in percentage form, thereby allowing investors and other uses to easily compare the profitability or effectiveness of different investment options. Here’s how to go about calculating this ratio:
To calculate return on investment, one must:
- divide the earnings from an investment (also called net profits) by the cost of the investment
- multiply the above result by 100
- mention the result in percentage format.
Here are two commonly used ROI formula:
- ROI = (Net Profit / Investment cost) x 100
- ROI = (Present value of investment – Cost of investment / Cost of investment) x 100
Let’s take an example to understand how the ROI calculation works:
Suppose you invested Rs. 5,000 in a stock ABC few years ago. You decide to now sell the stocks at Rs. 5,500.
The ROI on this investment will be:
ROI = (5,500 – 5,000 / 5,000) x 100 = 10%
The assumption in this calculation is that there are no:
- capital gains taxes or
- any buying/selling related fees
The main advantage of using ROI calculation is its mention in percentage format as against an amount. Investors can easily compare different ROI percentages of different investments across various categories. This can help them in identifying the investment that can offer the highest yield.
What are the main uses of ROI?
ROI can be used by investors to:
- evaluate existing portfolios
- compare across investment options
- make better investment decisions
ROI can also be used by business owners to:
- measure and compare investment avenues
- estimate the return on costs such as marketing, rental expenses, etc
It is important to keep in mind that ROI does not eliminate any risk or uncertainty associated with an investment. Therefore, when one uses ROI for making future investment choices, he/she must take into account the risk that the estimates or projections of earnings can involve. For instance, the projections may be too optimistic or could be too conservative. Also, historical performance of an investment is no assurance of the investment’s future success.
What is a good ROI ratio?
As per conventional theory, a yearly ROI of about 7% or more is considered to be good for stock market related investments. That being said, estimating the appropriate ROI for any investment requires investors to give careful consideration instead of going by a simple benchmark.
If an investor uses the Sensex performance as a benchmark for investing in stocks, it may not be appropriate considering the risk level that he/she is willing to take on or the risk associated with the asset class of investment.
To know what ROI is good for a certain investment, an investor must ask the following questions:
- How much risk appetite do I have?
- What if I lose the funds that I invest?
- How much profit do I want from this investment to bear the risk of losing money?
- What are the alternatives for using the available funds?
What are the benefits and flaws of ROI?
Some of the benefits and disadvantages of ROI metric are:
|Calculation||ROI can be easily calculated even by new investors. All it requires is one to know the cost and profit of an investment.||ROI is not self-sufficient as a metric and has to be used in conjunction with other metrics like return on equity and rate of return.|
|Usage||Easy to understand and use.||While it is easy to understand and use, some investors may not be aware of the aspects that are ignored by the calculation, such as inflation.|
|Multiple uses||ROI can be used by investors and corporations alike.||When companies use ROI for presentation purposes, they may manipulate the numbers to project positive earnings.|
ROI is an easy to understand and calculate metric for gauging the efficiency of an investment. It is widely used by investors to compare among multiple similar investment options. While using ROI can be a good start in evaluating an investment, investors must not stop at that. ROI should not be the only metric that investors use to make investment decisions, as it does not consider the risk or investment time horizon. ROI also requires one to use an exact estimate of all the associated costs.
One of the alternatives that can be used in place of ROI is annualized ROI. It takes into account the time period of investment, thereby allowing investors to make more accurate comparisons on returns from different investments.
Financial ratios are calculated using numerical values sourced from financial statements. These help in gaining a meaningful insight into a company’s performance. The numbers are sourced from a company’s financial statements, such as balance sheet, income statement, etc.
Investors often fail to consider transaction costs and dividends into the ROI for stock investments. The former is a cost associated with investment, whereas the latter is a gain from the investment. Only if both these are taken into account the ROI can give accurate results. If not, then the ROI can be misrepresented.
Some of the common metrics used in evaluating investment performance include absolute returns, annualized returns, rate of return, return on investment and CAGR or compounded annual growth rate.
Inflation reduces the power of the rupee. It is especially important while measuring fixed income returns since it has an inverse relation with interest rates. Inflation-adjusted returns offer a better insight to investors and tell the real returns on investment.