What is Return on Investment?
Return on investment (ROI) is a performance measure used to evaluate the efficiency or profitability of an investment or compare the efficiency of a number of different investments.
Important points on ROI
- Return on Investment (ROI) is a popular profitability metric used to evaluate how well an investment has performed.
- ROI is expressed as a percentage and is calculated by dividing an investment’s net profit (or loss) by its initial cost or outlay.
- ROI can be used to make apples-to-apples comparisons and rank investments in different projects or assets.
- ROI does not take into account the holding period or passage of time, and so it can miss opportunity costs of investing elsewhere.
How to calculate ROI?
To calculate the ROI two methods are there,
ROI= Cost of Investment / Net Return on Investment×100%
ROI= FVI−IVI / Cost of Investment×100%
FVI=Final value of investment
IVI=Initial value of investment
Advantages of ROI
- The biggest benefit of ROI is that it is a relatively uncomplicated metric.
- It is easy to calculate and intuitively easy to understand. ROI’s simplicity means that it is often used as a standard, universal measure of profitability.
- As a measurement, it is not likely to be misunderstood or misinterpreted because it has the same connotations in every context.
Disadvantages of ROI
- It does not take into account the holding period of an investment, which can be an issue when comparing investment alternatives.
- ROI does not adjust for risk. It is common knowledge that investment returns have a direct correlation with risk: the higher the potential returns, the greater the possible risk.
- ROI figures can be exaggerated if all the expected costs are not included in the calculation. This can happen either deliberately or inadvertently.
- ROI only emphasizes financial gains when considering the returns on an investment.