Return on investment"

Return on Investment: Definition, Formula, Example, and FAQs

Return on investment (ROI) is a widely used financial ratio that measures the profitability of an investment in relation to its cost. It is a fundamental metric within the broader field of investment analysis, serving as a crucial indicator for evaluating the efficiency and potential gains of various ventures. A high return on investment signifies that the benefits of an investment favorably compare to its associated cost of investment.

History and Origin

The concept of return on investment, while seemingly intuitive today, gained prominence in the early 20th century, particularly through the work of Donaldson Brown at DuPont. In 1914, as Assistant Treasurer, Brown developed a formula for monitoring business performance that integrated earnings, working capital, and investments in plants and property into a single measure. This innovation, which he termed "return on investment," later became known as the DuPont Model.¹² His work at DuPont and later at General Motors significantly advanced the application of financial disciplines and ROI concepts within large corporations, establishing it as a primary performance measurement tool for assessing the financial health of products and businesses.¹¹

Key Takeaways

Return on investment (ROI) quantifies the efficiency and profitability of an investment.
It is calculated by dividing the net profit of an investment by its initial cost and is typically expressed as a percentage.
ROI is a versatile metric applicable across various types of investments, from stocks to real estate and business projects.
While simple and widely used, ROI has limitations, including its inability to account for the time value of money or inherent risk.
A positive ROI indicates a net gain, while a negative ROI signifies a net loss.

Formula and Calculation

The basic formula for calculating Return on Investment (ROI) is:

\text{ROI} = \frac{\text{Net Profit from Investment}}{\text{Cost of Investment}} \times 100\%

Alternatively, it can also be expressed as:

\text{ROI} = \frac{(\text{Current Value of Investment} - \text{Cost of Investment})}{\text{Cost of Investment}} \times 100\%

Where:

Net Profit from Investment is the total revenue generated from the investment minus all expenses and the initial cost. This is effectively the net income attributable to the investment.
Cost of Investment refers to the initial outlay or total capital expenditure required to make the investment.

Interpreting the Return on Investment

Interpreting return on investment requires context. A positive ROI indicates that an investment generated a profit, while a negative ROI means it resulted in a loss. Generally, a higher ROI is more desirable, as it suggests greater efficiency in converting investment into profit. However, what constitutes a "good" return on investment can vary significantly based on the industry, the specific type of investment, the associated risk, and prevailing market conditions. For instance, a 10% ROI on a very low-risk bond might be considered excellent, whereas the same ROI on a high-risk venture might be seen as underwhelming. Investors often compare an investment's ROI against alternative valuation opportunities or a predefined benchmark to assess its relative attractiveness.

Hypothetical Example

Consider an individual, Sarah, who purchased 100 shares of Company X at $50 per share, totaling an initial capital outlay of $5,000. After one year, she sold all her shares for $60 per share, receiving $6,000. During her ownership, the company also paid out $200 in dividends.

Calculate Total Return:
- Sales Revenue: 100 shares * $60/share = $6,000
- Dividends Received: $200
- Total Return: $6,000 + $200 = $6,200
Calculate Net Profit from Investment:
- Net Profit = Total Return - Cost of Investment
- Net Profit = $6,200 - $5,000 = $1,200
Calculate Return on Investment:
- ROI = (Net Profit / Cost of Investment) * 100%
- ROI = ($1,200 / $5,000) * 100%
- ROI = 0.24 * 100% = 24%

Sarah's investment in Company X yielded a 24% return on investment. This hypothetical scenario illustrates how to quantify the financial success of an investment.

Practical Applications

Return on investment is a cornerstone metric used across various facets of finance and business. In portfolio management, investors use ROI to compare the performance of different assets, such as stocks, bonds, or real estate, within their holdings. Businesses commonly employ ROI in budgeting and capital assets allocation decisions, evaluating the potential profitability of new projects, marketing campaigns, or equipment purchases. Regulators, like the U.S. Securities and Exchange Commission (SEC), also provide guidance on how companies should disclose key performance indicators and other metrics, emphasizing the importance of clear definitions and contexts for investors to understand a company's financial condition and results of operations.¹⁰ Investment research firms like Morningstar rely on such metrics for their comprehensive analysis and ratings, guiding investors in assessing security strength and performance.⁹

Limitations and Criticisms

Despite its widespread use and simplicity, return on investment has several notable limitations. One significant drawback is its failure to account for the time value of money. ROI does not consider the duration over which the return is generated, meaning an investment yielding 20% over one year appears equal to one yielding 20% over five years, even though the former is clearly more efficient in terms of time. This can make direct comparisons between investments with different holding periods misleading.

Another criticism is that ROI does not inherently incorporate risk. A high ROI might come from a highly volatile or speculative investment, but the metric itself does not reflect this underlying risk. Consequently, an investment with a lower ROI but significantly lower risk might be a more prudent choice for some investors.⁸ Furthermore, ROI calculations can be manipulated by selectively including or excluding certain costs or benefits, leading to a biased assessment. It often provides a snapshot of profitability without the underlying data that forms its inputs, which can make it a "non-rigorous, amorphous bundle of mixed approaches, prone to the risks of inaccuracy and biased judgement."⁷

Return on Investment vs. Return on Equity

While both Return on Investment (ROI) and Return on Equity (ROE) are profitability ratios, they measure different aspects of financial performance and are often confused.

Feature	Return on Investment (ROI)	Return on Equity (ROE)
Purpose	Measures the efficiency of a specific investment or project relative to its cost, regardless of funding source.	Measures how much net income a company generates for each dollar of shareholders' equity.
Formula Basis	Net Profit / Cost of Investment	Net Income / Shareholders' Equity
Scope	Broader; can apply to any individual asset, project, or entire company's investments.	Specific to a company's ability to generate profit from the money invested by its owners.
Focus	Investment efficiency	Shareholder profitability / efficiency of equity utilization

ROI focuses on the overall return of a specific investment, considering all costs. ROE, on the other hand, specifically assesses how effectively a company uses the capital invested by its shareholders to generate profits. Therefore, while ROI is useful for evaluating individual projects or assets, ROE provides insight into how well a company is managing its ownership funds to create value.

FAQs

Q: Is a higher Return on Investment always better?
A: Generally, a higher return on investment is preferred as it indicates greater efficiency. However, it's crucial to consider the risk associated with the investment and the timeframe over which the return was generated. A lower ROI with significantly less risk might be more suitable for certain investment strategies.

Q: Can Return on Investment be negative?
A: Yes, return on investment can be negative. A negative ROI means that the cost of the investment exceeded the financial gain, resulting in a net loss. This indicates that the investment was unprofitable.

Q: How does Return on Investment relate to the time value of money?
A: The standard ROI calculation does not explicitly account for the time value of money or the duration of the investment. A 10% ROI earned in one year is different from a 10% ROI earned over five years. For time-sensitive comparisons, other metrics like annualized ROI, Net Present Value (NPV), or Internal Rate of Return (IRR) are often preferred as they incorporate time.

Q: What is a good Return on Investment percentage?
A: What constitutes a "good" return on investment varies widely. It depends on factors such as the industry, the type of investment (e.g., real estate, stocks, a new business venture), the level of associated liquidity, and current market conditions. A common benchmark for long-term equity investments might be around 7-10% annually, but this is not a universal standard.

Q: Is Return on Investment used for short-term or long-term investments?
A: Return on investment can be calculated for both short-term and long-term investments. However, its simplicity means it is often most effective for quick, back-of-the-envelope comparisons. For long-term investments, especially those with irregular cash flows, metrics that incorporate the time value of money or project life cycle are often more comprehensive.¹ ² ³ ⁴ ⁵ ⁶