Everything You Need to Know About ROI and ROI Calculation
Whether you’re in business or investing, you will constantly be weighing the advantages and disadvantages of the investments you make. As an investor, ROI and ROI calculation can help you decide where to get the best return for your money. As a business, it can help you develop a business case for a proposal or compare the potential return for different business decisions.
In this guide, we’ll break down the key concepts around ROI, discuss the pros and cons of using ROI calculations when making decisions, and discuss the limitations of ROI. First, however, we’ll start by defining the different types of ROI calculations.
- Return on investment (ROI) is a common profitability metric used to evaluate how well an investment has performed.
- ROI is measured as a percentage and is calculated by dividing the net gain (or loss) on an investment by the original cost or expense.
- ROI is relative and has some limitations, like ignoring the time value of money.
What Is ROI Calculation?
A ROI calculation is a performance measurement used to assess the profitability of a project or investment. ROI measures the amount of return gained in comparison to the cost of the project, thus the return you can expect based on the investment being made.
The ROI calculation is helpful in deciding which projects to fund or investments to make and judging the success or failure of projects when they are completed.
How to Calculate Return on Investment
The basic ROI calculation formula is fairly simple. You take the profit (revenue minus expense) divided by the expense. ROI is expressed as a ratio or percentage.
The Basic ROI Calculation Formula
ROI = [ ( Revenue – Expense ) / Expense ] x 100%
For example, if you spent $10,000 and made $15,000, your ROI would be 50%.
[ ( $15,000 – $10,000 ) / $10,000 ] x 100% = 50%
The basic ROI calculation provides a bottom-line number for a project or investment. However, it fails to take time into consideration. For example, how long an investment was held makes a difference. To see the difference, we need to look at the annualized ROI calculation.
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What Is Annualized ROI?
The annualized ROI calculation not only provides a measure of ROI, but it also analyses the annual ROI for projects or investments.
The Annualized ROI Calculation Formula
Annualized ROI = [ ( 1 + ROI )1/N – 1 ] x 100%
N = the number of years for an investment or project
The annualized ROI calculation is particularly important when you are looking at investments. Let’s take a look at the same calculation over a period of years using an annualized ROI calculation example.
Let’s say you had a basic ROI of 50% and realized this gain over five years. You might assume that the annualized ROI would be 50% / 5 or 10%, but this does not take into account the effects of compounding.
In actuality, here’s how the annualized ROI calculation formula would look:
Annualized ROI = [ ( 1 + 0.5 ) 1/5 – 1 ] x 100
You would get an annualized ROI of 8.45%.
If you achieved the same gain over a two-and-a-half-year period, the annualized ROI would be 17.61%. If you realized the gains in six months, the annualized ROI would be 125%.
Annualized ROI can be more useful in evaluating investments or projects over time because it also helps you more accurately compare investments across different holding periods. In practice, however, it’s not as simple as picking an investment with a higher annualized ROI. You also need to assess potential risks. Many times, a lower ROI with a significantly lower risk may wind up being a better or safer investment.
Interpreting the ROI
ROI can be used to assess almost any type of venture or investment and provides a way to compare them in a similar manner.
Let’s take the example of an eCommerce business that wants to invest $100,000 in digital advertising and generates $400,000 in revenue. The ROI would be 300%.
($400,000 – $100,000) / $100,000 x 100% = 300%
While that seems pretty straightforward, it can get tricky to determine whether that’s really a good return. 300% sounds great unless you find out you could have earned 400%.
ROI can also be difficult to calculate for intangibles. Many other variables impact the effectiveness of your revenue, such as competitor pricing, user experience on your website, how well you targeted your advertising, the quality of your merchandise or service, and plenty of other variables. Not optimizing any of these variables may have actually impacted your potential ROI positively or negatively.
Not understanding the potential ROI of other investments can also prevent you from achieving greater returns.
ROI Calculation Excel
There are a few different ways to calculate ROI easily. You can use a free online ROI calculator, or you can create an Excel spreadsheet with formulas to do it for you.
In Excel, you need to know the two variables for ROI: the cost of the investment and the profit or loss. Enter the profit or loss on the first line and the expense on the second line like in this example.
In cell B5, enter this formula: =B2/B3
And then format B5 to display as a percentage by right-clicking on the cell and choosing Percentage from the category menu.
ROI Calculation and Financial Decisions
ROI can help you make good financial decisions, but keep in mind the ROI is relative. In other words, what is a good ROI? It depends.
Comparing Investments and Annualized ROI
The average return on the stock market has historically been about 10% annually without adjusting for inflation. It’s been that way — on average — for nearly a century. Accounting for inflation, it’s about 7% for S&P 500 stocks. Some years may be higher while others are lower, but let’s take 7% as a benchmark.
When you are evaluating investments, it’s fair to compare them to the benchmark. If you could realize that 7% by investing in an S&P 500 index fund, for example, a 5% return on investment elsewhere might feel like it’s missing the mark. However, your decision on where to invest will likely not be based solely on the ROI.
Other factors, such as the amount of investment, your risk tolerance, whether you can afford to lose money on your investment, and the liquidity of your investment. There’s also the question of what else you could be doing with the money. An 8% return might seem like a good deal compared to the benchmark, unless there’s an investment with a similar risk profile that nets 10%.
ROI Can Also Be a Moving Target
ROI metrics can vary greatly over time. When evaluating a business proposal, for example, you will likely be looking at uneven cash flows, such as seasonal trends. ROI can fluctuate greatly quarter by quarter or year by year.
For example, most retail outlets generate nearly 20% of their annual revenue from holiday sales. Depending on when the ROI snapshot is taken, it can tell entirely different stories.
Combining Leverage With ROI
Another variable is leverage. Leverage comes into play when you are using borrowed money to find investments and generate returns. Most commonly, this comes in the form of debt or loans.
Investors use leverage to multiply their buying power. If they can earn gains that exceed the cost of the borrowed money, it’s a win. However, it can also be risky. If the investment does not perform as anticipated, it can magnify losses or reduce the amount of the gain, since you’re paying for the cost of using the capital.
One common form of leverage for stock investors is buying on margin.
The Advantages and Disadvantages of ROI
There are advantages and disadvantages to using ROI or annualized ROI in evaluating investments for individuals and companies. Let’s explore some of them.
ROI is helpful to compare the relative outcome of various projects or investments to make better financial decisions and allow companies or investors to maximize their profit. The ROI calculation is easy to understand for those that are not accountants or CFOs.
ROI is also helpful in:
- Measuring the performance of specific investments.
- It can be used to evaluate business unit performance.
- Making sure investment goals are aligned.
- Tracking performance over time.
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ROI also has some significant limitations that businesses and investors need to understand. Perhaps the biggest one is that ROI ignores the time value of money.
The time value of money (TVM) posits that money is worth more today than it will be in the future because of its ability to earn over time. In other words, $10,000 today is worth more than $10,000 five years from now because of what you can do with it in the interim. Another way to think of this is that money in the future has lost the opportunity to earn during the time (lost opportunity cost).
Another potential disadvantage, when comparing ROI, is that different variables may impact the equation. For example, some companies will calculate the return on investment based on gross margin rather than profits. Others may define ROI based on their definition of profit, which might mean gross profit, net profit, profit before interest and taxes, etc.
To avoid this limitation, when comparing investments or companies, it is crucial to make sure you are comparing apples to apples. The accounting methodology and ROI calculation must use the same variable to provide a fair evaluation.
In business and investing, there’s more to consider than just the ROI as well. Besides risk, there is also the impact of choosing the wrong investment, even if it has a higher ROI. For example, an investor may produce a higher ROI but also be consolidating their risk because of a lack of diversification. When making decisions, ROI is relative to an investor’s overall goals.
A business might invest in projects that have a high ROI while not considering the long-term impact that the investment may have on other areas of the business. Money may be directed towards one area that has a high ROI, but should really be applied to other divisions or areas to protect business assets or grow the long-term value.
Here’s an example. Let’s assume that you know by investing your capital in marketing efforts, you can generate a high ROI by increasing sales. However, if you have limited capital, it may be a smarter business decision to use the same funds for additional product development to grow your potential customer base. In that case, the high ROI for the marketing investment may sway you from investing your dollars in the best manner for your business.
Therefore, ROI calculation can help measure the profit of an investment, but it is better to evaluate the investments in a reasonable time frame to determine the actual profit margins or percentage of profit.
As a way of summary, here are quick answers to some of the most frequently asked questions.
The ROI calculation measures the return you get in exchange for the investment you make.
You can calculate the basic ROI by taking the profit and dividing it by the expense to create a percentage or ratio. You can also calculate an annualized ROI rate to evaluate the rate of return over time.
Calculating ROI gives you an easy way to compare different investments or projects to determine which will provide a better rate of return.
ROI does not take into account risk or the time value of money.
While the formula for calculating ROI stays the same, some businesses use different variables to define profit and expenses, which can make comparison difficult.