If you’re investing money, your goal is usually to make money. This is why you need to evaluate all potential investments to determine which one will give you the most value. But how can you compare different options?
Return on investment (ROI) is a common metric used to determine how much money you will earn relative to your investment. It is usually shown as a percentage and can be a useful metric when comparing different investment opportunities.
Let’s look at ROI more in depth and how it can help you make better investing decisions.
What is return on investment (ROI)?
ROI meaning Return on Investment (ROI) is a metric that tells you how much you gain or lose from an investment compared to the amount of money you put in. It’s expressed as a percentage and is a handy way to determine which investment option will result in earning the most.
ROI is commonly used in business when deciding between different options for investing capital. Individual investors also use ROI to determine which stock or bond option will give them the most bang for their buck.
How to calculate ROI
Calculating ROI is not complicated. To determine your ROI, take the profit from an investment and divide it by the cost of that investment, then multiply it by 100.
ROI formula ROI = [(current value of investment - cost of investment) / cost of investment] x 100
Let’s look at how this would be applied in a real-life scenario: Let’s say John buys shares of a company’s stock. He pays $1,500 for the shares and sells them a year later for $2,000. What was his ROI?
To calculate the return on John’s investment, take the profit ($2,000 - $1,500 = $500) and divide it by his total investment cost ($1,500) then multiply by 100 percent. This gives an ROI of 33 percent (rounded). John was proven right: This was a good investment for his money.
Why ROI is important
Calculating ROI can tell you which of your investments are making you the most money and which ones are making you less or even resulting in a loss.
ROI can help you evaluate where you should put more of your capital and where to pull back at any given time. If investing in stocks and bonds, it’s important to evaluate your ROI over the long term as short-term market fluctuations can skew your results.
It can also help you compare two different investment options such as investing in stocks vs. real estate. (It’s always important to do your research and understand the inherent risk for each asset class before handing over your cash.)
If you’re running a business, ROI can be an important measure to help determine where to invest more of your capital. For example, if you’re running a pay-per-click (PPC) marketing campaign, you want to test different advertising strategies to see which one gives you a better ROI on dollars spent.
Knowing how well something is converting can help you focus on what is bringing you money and what isn’t. The better idea you have of the ROI if your efforts, the better you can maximize profits.
What is a good ROI?
Many companies strive for a 5:1 return on investment when evaluating whether the money they’ve spent has been put to good use. But that can be an aggressive goal for inexperienced investors or young businesses. It’s important to research what is a good ROI for the area where you plan to invest so you can have a good benchmark.
Inflation plays a big role in return on investment, especially over the long term. One dollar today does not have the same purchasing power a year from now. According to the Bureau of Labor Statistics, inflation was at 2.1 percent for the first half of the year.
What a good ROI is varies by asset class. For example, cash has a bad ROI over the long term since it depreciates over time. Hiding cash “under your mattress” is a bad long-term investment plan and will result in a negative return on investment.
If you take that cash and invest it in quality bonds, you can expect a 2 to 4 percent return on investment after taking inflation into account. However, investing in junk bonds can result in higher or lower ROI, depending on default rates.
Return on investment for real estate depends on several factors, including the type of property (commercial or residential), the debt leverage, the inherent risk, and so on. Riskier projects tend to promise higher rates of return.
How to use ROI
If you’re looking to compare investment opportunities, ROI is one useful measure. It will show you which use of capital will make you the most money, all other things being equal.
Businesses often use return-on-investment projections to decide which initiatives would be best to invest in based on potential profitability.
Let’s say you have $10,000 in your retirement account and you’re looking to invest and grow your stash. Looking at your portfolio returns for the past 12 months, you calculate that Company A has given you an ROI of 20 percent on your money. However, Company B has given you an ROI of 25 percent in your invested funds, making it the clear winner.
ROI limitations
While ROI is a useful metric for determining which investment will result in the greatest growth, it’s only one piece of the puzzle. That’s because return on investment does not take into account other important factors like risk and time frame.
The more risky the investment, the higher the projected ROI, which may make it an attractive option. However, riskier investments could mean losing money, which will bring your ROI down to zero and cost you your capital.
This is the case with junk bonds and shares of start-up companies. Both investments have the potential for big returns but only if the company does not fail. Lower credit rated companies offer bonds with higher interest rates to compensate investors for the added risk.
In many situations, ROI is calculated as a projection rather than current returns, which tells you what you have to gain from an investment but it doesn’t account for potential losses.
Another factor to keep in mind is the timeframe for the ROI calculation. Getting a 20 percent ROI on an investment may sound nice until you realize it will tie up your money for up to five years. This can make a 12-month investment that returns 10 percent a much better deal
Calculating ROI also doesn’t allow for taking into account non-financial benefits from the investment. For example, a coffee company that sources coffee beans using fair-trade practices may end up paying more for them than standard sourcing. Their ROI would be lower but it wouldn’t account for the increase in the company’s reputation or the improved welfare of the regions and people impacted by these practices.
The Bottom Line
While it’s important to understand ROI and how it applies to investing, it shouldn’t be the only metric used when evaluating potential opportunities. With that said, every investor and business owner must understand ROI and learn how to calculate it.
When making a decision about an investment, use ROI as one of several tools to evaluate different options. It can play an important role in giving you a more rounded picture and helping you understand the potential upsides and downsides of an investment.
