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What Is ROI?
ROI is a profitability ratio that calculates the rate of return on an investment relative to its cost. An ROI figure is a percentage used by both individual investors and companies to compare the efficiency of different investments. The higher the net profit and the lower the investment cost, the higher the ROI. Companies will also use a projected ROI to help estimate returns on potential investments to see if the cost of capital will be worth it.
How to Calculate ROI
To calculate the return on invested capital, you take the gain from investment, which is the amount of money you earned from the investment, minus the cost of the investment; you then divide that number by the cost of the investment and multiply the quotient by 100, giving you a percentage.
This formula for calculating RO is as follows:
ROI = (gain from investment – cost of investment) / cost of investment *100%
Example of ROI
The ROI formula can be used for any investment and is often used with real estate purchases to help evaluate a property’s value.
For example, say the initial cost of investment for a house you bought was $200,000, but you spend $50,000 renovating it. The total cost of your investment is now $250,000. If you sell the house for $350,000, you earn a profit of $100,000 (gain from investment minus the cost of investment). Divide that net profit ($100,000) by the cost of your total investment ($250,000) and then multiply by 100 to get your ROI—which equals 40 percent. You can now compare that number with other real estate purchases and see which sale yielded the highest return.
What Are the Limitations of ROI?
Although investors use projected ROI to estimate the value of an investment, the return on investment formula is only one method of financial evaluation. One of the main problems with using ROI is that it does not paint a complete picture of the economic landscape. ROI has two primary shortcomings:
- ROI does not include a calculation of risk. It may seem straightforward to pick the company whose ROI is highest when investing, but because risk is not a factor considered, ROI does not indicate how much money an investor stands to lose. A higher ROI percentage usually means more risk involved, and that the investment is more susceptible to market fluctuation.
- ROI does not factor in time. When determining the potential value of an investment, it’s important to know how much money it will recoup over a certain time period. However, the return on investment formula does not factor in the length of time needed to realize capital gains. For example, if you are trying to choose between two companies to invest in, where Company A offers a rate of return of 25 percent, and Company B offers a higher return of 30 percent, you may be inclined to choose Company B—after all, that’s a good ROI. However, if Company A offers their 25 percent rate over a period of two years, and Company B offers their 30 percent rate over a period of five years, then Company A would be a smarter financial decision—which is where the ROI formula falls short.
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