What is return on investment?
Return on investment or ROI is a performance measure used to calculate the gains or losses of an investor resulting from an investment in order to compare it to the efficiency of other investments. It measures the amount of returns made from an investment as a percentage of the purchase price. A higher ROI would mean that the investment has made favorable profits relative to its cost
The ROI calculation is one of the most used profitability ratios because it is straight forward and extremely versatile. Investors can use it as a rudimentary gauge of an investment’s profitability or to compare the overall performance of other investments in a portfolio.
To calculate for the ROI, the gains from the investment are divided by its cost. The result is usually expressed as a percentage or a ratio. The formula for ROI is as follows:
A simpler formula would be:
For example, an investor purchases $500 worth of stocks and makes a profit of $620 after selling the stocks in a few years. The calculation of ROI would be as follows:
ROI = ($620 – $500) / $500 = 0.24 * 100 = 24%
The ROI from the given example would be 24%. The calculation could be more accurate if the taxes and fees are deducted beforehand.
Purpose and limitations of ROI
In investing, the ROI metric is used to measure the returns made on an investment. It helps compare different investments within a portfolio. The investment with the largest ROI percentage is usually prioritized while the investments with the lowest ROI are taken into account.
Calculating the ROI simply shows how returns compare to the costs. However, it does not include anything about the risk of an investment or the projected profits an investment will make in the future. A good analysis of an investment does not stop with calculating the ROI, rather, it also includes taking into consideration its risks and the different factors that affect it.
ROI is commonly used due to its simplicity and versatility. It is simple to use because it is easy to calculate with the right parameters and it is versatile because it can be used both to gauge the efficiency of an investment and to compare other investments as well. But ROI also has its downsides.
One of these downsides is its flexibility. ROI calculations can be easily manipulated to suit the user’s purposes. Because of this, the results may vary among users. Thus, it is important to use the same inputs to get accurate comparisons.
Another downside is the amount of time of which the ROI is calculated. Investments only recognize profits after they are sold, which length of time varies. An investment sold after 3 years may seem to make a higher ROI compared to an investment sold after a year, but carefully looking at the results may conclude that the latter actually has a higher annual ROI. Since there is no standard time calculated, the results of ROI may seem inaccurate in some cases.
Lastly, the calculation for ROI only focuses on dividing the net income by its cost. It does not involve the calculation of the cost and the other intermediary expenses like taxes, fees, etc. This is another limitation of ROI that makes its result a little inaccurate.
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