Return on Investment (ROI) - Explained
What is a ROI?
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Table of ContentsWhat is Return on Investment?Example of Return on InvestmentHow is Return on Investment Used?Academic Research on Return on Investment
What is Return on Investment?
Return on investment (ROI) is a profitability ratio used for measuring the amount of profit generated by an investment relative to its cost. It evaluates the cost efficiency of an investment and is expressed as a percentage or ratio. It is calculated as the return of an investment divided by the cost of the investment. The formula for computing the ROI is,
ROI = Profit Margin / Cost of Investment
ROI = (Gain from Investment - Cost of Investment) / Cost of Investment
The gain on investment is the increase in value of an asset. The gain on investment minus the cost of investment is known as the profit margin.
If the investment is in products to be sold (rather than a single asset), then you will need to know the total quantity of goods purchased for sale and the total sales volume. This is important, as the cost of investment will include all products purchased. Your profit margin will be determined based upon how many items you sell.
Example of Return on Investment
For example, if an individual invests $1000 for 100 units ($10 per unit) of inventory. After a year, he or she sells the inventory at retail for $15 each of $1500 if all are sold. Then the profit margin is $5 per unit ($15 - $10 = 5) above the value of the initial cost or investment. Thus, the return on investment is $5/$10=0.5 or 50% per unit. To calculate the ROI for the entire investment, you will need to know the sale volume.
If you sell all of the product, your RIO is 50%. If you sell less than the entire amount of inventory, the ROI will be less. For example, if you sell 90 units, the gain on investment is $1350 (90 x $15 = $1350). The ROI is then 350/1000 = .35 or 35%.
How is Return on Investment Used?
ROI is used for comparing returns from various investments that allow the investor to invest their capital efficiently. It is the most common indicator used across different types of investments. It is easy to calculate the ROI because of its simplistic nature; although, for companies it is a bit more complicated when there are several inputs. The investors compare the ROI of different investments and it is always better to go for a higher ROI. Negative ROI depicts a loss, so those investments should be avoided. ROI allows the investors to make an informed decision when investing their money. It is important for investors to use the same inputs for calculating ROI while comparing different investments. One shortcoming of comparing ROIs of similar project is it doesn't take time into consideration.
Suppose, an individual invests $2,000 to buy stocks of a company. One year later he sells it at $2400. The profit from the investment is ($2,400-$2000) = $400 and ROI is $400/$2000= 0.2 or 20%. Then the same individual buys stocks of a company with $4000 and sells those shares in the market 3 years later at $4800. His profit from the investment is ($4800-$4000) = $800 and the return on investment is $800/$4000=0.2 or 20%. So apparently the ROI is the same for both the investments, but in the first case it took only one year and in the second instance it took three years. So, the first investment is more profitable than the second one although the ROI is the same for both.
Thus, ROI provides a simplistic estimate of the profitability of an investment. As such, other indicators must also be taken into account when comparing different investments. The Rate of Return or Net Present Value can be used along with ROI to get a more accurate estimate.
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