Making It Easy To Understand Return On Investment (ROI)
Return on Investment Explained
Return on investment (ROI) or rate of return is simply 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 to choose from: savings accounts, real estate, stocks, business and capital upgrades. So how does ROI play a role and help us decide which to choose?
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 and elimination before settling down on the best possible option(s). Furthermore once an investor has chosen the best 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:
Return on Investment = (Gain or Loss on Investment) / (Cost of Investment + Any Related Expenses)
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. For example one investment may provide a consistent returns over a 5 year period while another investment may earn returns over the lifetime of a customer. The first investment would be rather simple to calculate by taking into consideration the interest rate and time value of money. The second investment may be a lot more difficult to calculate when you take into consideration all future purchases and referrals for new business, in addition to rate of return and time value of money. Suddenly ROI becomes much trickier to calculate!
This is especially important when making comparisons between different investments as related to marketing or advertising campaigns. 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 to suit many different investment situations.
Even so, there are disadvantages to its flexibility in that ROI calculations can be manipulated for various purposes and can often be confusing. This is why it is important to clearly understand the inputs when calculating ROI.
Tips for Calculating ROI
When calculating and comparing ROI it is important to note the factors that may influence the investments which can include:
- Interest rates
- Currency fluctuations
- Depreciation and appreciation on investments
Without taking these factors into account ROI may exaggerate the actual economic value and cause decision makers to make uninformed choices. Exaggeration may depend on factors such as
- Investment duration
- Capitalization policies
- Depreciation rates
- Investment growth rates
- Lag between outlay and earnings
Overall, ROI depends on many factors so investors must be clear on the influential inputs and have up to date information on their investments to calculate an accurate and useful ROI value.