Return on Investment (ROI)
What is ROI?
Return of Investment (ROI) is one of the basic metrics in financial analysis. It measures how much financial gain (or loss) an investment brings compared to the total cost of this investment. In other words, ROI shows how much more (or less) money you get after completing a project compared to what you have invested in it. To make a measure more convenient and better suitable for comparisons, ROI is usually expressed in percentage.
When you set out to calculate the ROI, all the data you need to do so is in your books. So if you need any help with getting them in order, check out our accounting services.
Who and Why Needs ROI
ROI is commonly used to evaluate the attractiveness of financial investments. It is simple and straightforward, so ROI can be applied to many types of investments: buying currency, or developing property, or purchasing an art object, or investing in a startup.
Investors use ROI when comparing potential investments: those with higher ROI are generally more attractive as they bring higher returns on the same amount of money invested.
Entrepreneurs include ROI estimations into their pitch for investors. ROI is a universal and easy-to-understand measure which gives investors a better picture of the business.
Companies use ROI to decide where to allocate their resources. For example, a company can calculate a Social Media ROI which measures the return from the social media activities (adverts, promotions, etc.). In this case, the cost of investment includes all expenditures related to the company’s activity in social media, such as payments to the agencies, cost of ad development. The benefits from this investment is an increase in sales.
How to Calculate ROI
The general formula of ROI is
ROI = Net Return on Investment/Cost of Investment * 100%
To calculate the Net Return, use the following formula:
Net Return on Investment = Total Gain from Investment - Cost of Investment
The Total Gain from Investment is a sum of all the financial benefits resulting from an investment.
If you buy a plot of land, build a house on it, and then sell it, your total gain from this investment will be the money that you get from the house sale. To calculate ‘Net Return of Investment’, you will need to subtract from it the ‘Cost of Investment’ which in this case includes cost of buying the land and cost of building the house.
The alternative way to calculate ROI is:
ROI = (Final Value of Investment - Initial Value of Investment)/Cost of Investment * 100%
Here, ‘Initial Value of Investment’ is the financial value of an asset at the moment when you invest in it. Correspondingly, ‘Final Value of Investment’ is the financial value of this asset at the moment when investment is terminated.
If you buy a famous painting at the auction, the price you pay is the initial value of this painting. If in a couple of years you sell the painting at a different price, this will be the final value of this painting.
Using both formulas should in theory provide the same result. However, in practice different analysts can include different measures in the formula which can result in different ROI for the same investment (more on this in Limitations of ROI).
Example 1: Simple ROI
In 2019 an investor bought 20 stocks of HappyShark Corp. at a price of 100 GBP per stock. In 2020 the investor sold these stocks at a price of 110 GBP. While holding the stocks, the investor received 400 GBP in dividends. For each transaction they paid 50 GBP as a trading commission. The ROI of this investment is
ROI = [(110 - 100)*20 + 400 - 2*50]/100*20 *100% = 25%
Here, the first part of the numerator is the capital gain (gain from selling the stocks, before commission), the second one is the dividend (400 GBP), and the last one is the commision paid (100 GBP). The denominator is the price of 20 HappyShark Corp. stocks at the moment of purchase (2000 GBP).
Example 2: Annualised ROI
Imagine two projects A and B with the same ROI of 20%. One of them achieved this mark in 2 years, but it took the second one 5 years to do the same. It may look like the projects are equally attractive to an investor, but it it not true. Generally, investors would prefer a project that brings profit faster.
Simple ROI does not help to count how fast the profits are achieved, and this is where Annualised ROI comes in handy. Annualised ROI measures profitability of investments on a yearly basis. If n is a number of years over which an investment is held, Annualised ROI can be calculated as
Annualised ROI = [(1+ROI)1/n−1]×100%
Using this formula, we can calculate and compare Annualised ROI for two projects A (2 years) and B (5 years) with the same ROI of 20%.
Annualised ROIA = [(1+0.2)1/2−1]×100% = 10%
Annualised ROIB = [(1+0.2)1/5−1]×100% = 3,7%
Project A has a higher Annualised ROI which means that an investor can get a higher return in one year.
Example 3: ROI with Leverage
Leverage means that an investor partly finances their investment with a loan. Investors usually use leverage to increase the expected returns. At the same time, leverage can magnify the loss if an investment does not turn out to be profitable.
Remember the investor who bought 20 stocks of HappyShark Corp.? Let’s say the company uses only 1000 GBP of investor’s money and borrows the remaining 1000 GBP from a bank, with an interest rate of 10%. This will have an effect on the values used to calculate ROI.
Now the cost of investment is only 1000 GBP as this is the amount of investor’s own funds used. To calculate the net return, we need to subtract the interest rate paid to the bank (10%*1000 = 100 GBP) from the total gains from investment. The ROI calculation will look like this:
ROI = [(110 - 100)*20 + 400 - 2*50 - 100]/1000 *100% = 30%
Using 50% leverage, the investor managed to increase ROI by 5%, from 25% to 30%.
Limitations of ROI
While a simple and informative measure, ROI also has its drawbacks.
First, ROI does not account for the time aspect of investments. Annualised ROI addresses this problem, but still misses some important factors. In investment analysis, it is often assumed that the value of 1 GBP today is not the same as the value of 1 GBP in 10 years. This is due to the fact that 1 GBP now can be invested (or put in a bank), and in 10 years bring the interest. In order to better account for this, it is useful to also calculate some metrics which consider a discount factor, such as Net Present Value (NPV) or Internal Rate or Return (IRR).
Second, ROI does not take into account any risk measure. Consider two investment alternatives A and B, with expected ROI 50% and 30% correspondingly. Comparing only the ROI values, a rational investor will choose project A. Imagine, that an investor also learns that in case of negative market developments investment A will lose 60% and investment B - only 5%. With this further information, an investor's preference might change, depending on their attitude to risk.
Third, ROI is relatively easy to manipulate. The formula for ROI includes general categories of “gain” and “cost”, without specifications on what exactly is included in them. For instance, if in the first example where an investor buys 20 HappyShark Corp. stocks, they forget (or purposefully omit) the trading commision, the ROI of the investment will increase from 25% to 30%. That’s why it is very important for both investors and entrepreneurs to understand well what cost and benefits the project has. When you see a ROI value, it is always useful to ask “Where exactly do the numbers come from?”
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