Financial metrics help make the right financial decisions. Whether you want to invest in the stock market or buy a property, consider the return on the amount you invest and then make a decision. Investors calculate and consider various financial ratios before making an investment decision. Return on Investment is a measure that is used to examine the efficiency of an investment. It also helps compare the return on different investment products. ROI formula measures the return generated on a specific investment, keeping the investment cost in mind. If you want to calculate the ROI, the return of investment or gain, should be divided by the investment cost. The result will be a ratio or a percentage.
ROI formula = (Current value of investment – Cost of Investment) / Cost of investment
The current value of the investment is the amount generated from the sale of the investment. Since ROI is reflected in the form of a percentage, you can easily compare it with returns on different investment products. It allows you to measure the return generated from different investment products against one another.
Importance of ROI
Return on investment is a very popular metric due to its simplicity and versatility. It could be used as a measure to gauge the profitability of an investment. You can use the ROI to evaluate the return on stock investment or the ROI you expect on the expansion of the business or an ROI generated from the sale of a property. The calculation is not complicated and it is easy to understand for its different range of applications. When the ROI is positive, it is worthwhile to make an investment. However, if there are other opportunities that have ROIs available, they can help you choose the right options. You should avoid negative ROIs because they mean a loss.
ROI is simple and it can aid in decision making. You can decide whether to make an investment or skip it. The calculation also shows how the investment has performed to date. Whether there is a positive ROI or a negative ROI is an important indication of your investment value. Using the formula, it is possible for you to separate the negative or low performing investment from high performing investment. It allows investors to optimize their investments.
Even if you are new to the field of real estate or the stock market, you can use the ROI to get an insight into the performance of the asset. Consider the ROI whenever you have to make a decision. It is the easiest way to understand whether your investment will generate positive returns or not.
Example of ROI formula calculation
Let us assume you purchase a property valued at $300,000 and two years later, you sell it for $500,000. You gained $200,000 from the transaction. Now let us use the ROI formula here.
ROI = 200,000/ 300,000 = 0.67
There is no ideal ROI. It will depend on the investment product you are considering and the period of time you have in mind. However, a higher ROI is better in all cases.
Benefits of ROI
Discussed below are the benefits of using an ROI before you make an investment decision.
Simple and straightforward: ROI is easy to calculate and you only need basic information like the cost of investment and profit earned. There is no complex formula and you do not need the help of a finance professional to understand ROI.
Globally accepted: This formula is used across the world. You can use it to calculate any investment idea with ease.
Versatile: The biggest advantage of ROI is that it is not only restricted to a particular industry or information. You can use an ROI for the stock market, for the real estate industry or a business opportunity. The same formula can be used across any industry and you will get an insight into the viability of it.
Limitations of ROI
Discussed below are a few limitations of ROI
It does not consider the time value of money: This is a big drawback of ROI. Different schemes will have different maturity periods and tenure. Hence, a 50% ROI for an FD and a 50% ROI for an ELSS is not comparable. It does not provide accurate information and might not help in decision making. In this case, the rate of return can score as a performance metric.
It does not consider inflation: ROI will not consider inflation or other additional costs like processing fee or stamp duty. These costs are a significant part of the cost of sale and they have an influence on the rate of return.
Considering the above-mentioned pros and cons of ROI, it can be concluded that the pros outweigh the cons. ROI is a useful financial metric and it provides important information for making an investment decision. The metric is easy to calculate and understand. What makes it important in today’s world is its versatility. Before you make any investment decision, it is advisable to consider the ROI and make comparisons between different products.