Making It Easy To Understand Return On Investment (ROI)
Return on Investment Explained
Return on investment (ROI) or rate of return is a way of measuring and evaluating the efficiency of an investment. ROI is calculated by looking at the ratio of money earned or lost versus the money spent on an investment. There are various types of investments that one may invest in such as savings accounts, real estate, stocks, businesses and capital upgrades. So how does ROI play a role?
By looking at the ROI on different forms of investment options, an estimate of the profit can be easily visualized. Thus calculating ROI aids in investment selection before settling down on the best possible option(s). Furthermore once an investor has settled down on an option, ROI also aids in calculating profit or loss on investment if there are any changes to figures such as interest rates or inflation.
Finally, ROI can be used to compare the profits when the money gained or lost cannot be easily compared. ROI is normally expressed as a percentage and correlates with the profit or loss made on an investment. Which is to say, the higher the positive ROI calculated, the higher the profits or capital growth and conversely, a negative ROI value is associated with loss or exponential decay.
However, ROI does not give an indication of the duration an investment is held, nevertheless it is most commonly calculated as annualized ROI, which takes the timing of investments, return and compounding into consideration.
Calculating Return on Investment
In order to calculate ROI a simple formula is devised where ROI = (Gain or loss on investment) / (Cost of Investment + any other expenses on investment). However, ROI can be calculated for different time periods from one day to years so it is important to note the time periods on which the ROI is calculated.
This is especially important when making comparisons between different investments. Further, when comparing ROI, fees and expenses must be included to ensure that a fair comparison can be made. ROI is a very popular metric because of its versatility in that the ROI calculations can be modified to suit different situations.
Even so, there are disadvantages to its flexibility in that ROI calculations can be manipulated for various purposes and can often be confusing. That being said, it is important to be clear as to what the inputs are when calculating ROI.
Tips
When calculating and comparing ROI it is important to note the factors that may influence the investments: These may include changes in interest rates, currency fluctuations, depreciation and appreciation on investments. ROI may also exaggerate economic value.
Exaggeration may depend on factors such as
1) Investment duration,
2) Capitalization policies,
3) Depreciation rates,
4) Investment growth rates and
5) Lag between outlay and earnings.
Overall, ROI depends on many factors so investors must be clear on their inputs and have up to date information on their investments to calculate an accurate and useful ROI value.
