Return on Investment (ROI): How to Calculate It and What It Means

What Is Return on Investment (ROI)?

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. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost.

To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.

How to Calculate Return on Investment (ROI)

The return on investment (ROI) formula is as follows:

$\begin{aligned} &\text{ROI} = \dfrac{\text{Current Value of Investment}-\text{Cost of Investment}}{\text{Cost of Investment}}\\ \end{aligned}$​ROI=Cost of InvestmentCurrent Value of Investment−Cost of Investment​​

"Current Value of Investment” refers to the proceeds obtained from the sale of the investment of interest. Because ROI is measured as a percentage, it can be easily compared with returns from other investments, allowing one to measure a variety of types of investments against one another.

Why Is ROI a Useful Measurement?

ROI is a popular metric because of its versatility and simplicity. Essentially, ROI can be used as a rudimentary gauge of an investment’s profitability. This could be the ROI on a stock investment, the ROI a company expects on expanding a factory, or the ROI generated in a real estate transaction.

The calculation itself is not too complicated, and it is relatively easy to interpret for its wide range of applications. If an investment’s ROI is net positive, it is probably worthwhile. But if other opportunities with higher ROIs are available, these signals can help investors eliminate or select the best options. Likewise, investors should avoid negative ROIs, which imply a net loss.

For example, suppose Jo invested $1,000 in Slice Pizza Corp. in 2017 and sold the shares for a total of $1,200 one year later. To calculate the return on this investment, divide the net profits ($1,200 - $1,000 = $200) by the investment cost ($1,000), for an ROI of $200/$1,000, or 20%.

With this information, one could compare the investment in Slice Pizza with any other projects. Suppose Jo also invested $2,000 in Big-Sale Stores Inc. in 2014 and sold the shares for a total of $2,800 in 2017. The ROI on Jo’s holdings in Big-Sale would be $800/$2,000, or 40%.

What Are the Limitations of ROI?

Examples like Jo's (above) reveal some limitations of using ROI, particularly when comparing investments. While the ROI of Jo's second investment was twice that of the first investment, the time between Jo’s purchase and the sale was one year for the first investment but three years for the second.

Jo could adjust the ROI of the multi-year investment accordingly. Since the total ROI was 40%, to obtain the average annual ROI, Jo could divide 40% by 3 to yield 13.33% annualized. With this adjustment, it appears that although Jo’s second investment earned more profit, the first investment was actually the more efficient choice.

ROI can be used in conjunction with the rate of return (RoR), which takes into account a project’s time frame. One may also use net present value (NPV), which accounts for differences in the value of money over time due to inflation. The application of NPV when calculating the RoR is often called the real rate of return.

What Is a Good ROI?

Determining what constitutes a "good" ROI is crucial for investors seeking to maximize their returns while managing risk. While there's no universal benchmark, several factors influence what's considered satisfactory.

• Risk tolerance: Investors vary in their willingness to tolerate risk. Those who are more risk-averse may accept lower ROIs in exchange for greater stability and predictability in their investments. On the other hand, risk-tolerant investors may seek higher ROIs but are willing to accept greater uncertainty and volatility.
• Investment duration: The time horizon of an investment plays a significant role in determining what qualifies as a good ROI. Longer-term investments typically require higher ROIs to justify tying up capital for an extended period. Shorter-term investments may offer lower ROIs but provide liquidity and flexibility.
• Industry norms: Different industries have varying expectations for ROI based on factors such as market conditions, competitive landscape, and regulatory environment. For example, industries with high barriers to entry or significant capital requirements may require higher ROIs to attract investment.
• Personal goals: Ultimately, what qualifies as a "good" ROI depends on an investor's specific financial objectives. Whether aiming for wealth accumulation, income generation, or capital preservation, investors should align their ROI expectations with their individual goals and circumstances.

What Are the Wider Applications of ROI?

Recently, certain investors and businesses have taken an interest in the development of new forms of ROIs, called social return on investment (SROI). SROI was initially developed in the late 1990s and takes into account broader impacts of projects using extra-financial value (i.e., social and environmental metrics not currently reflected in conventional financial accounts).

SROI helps understand the value proposition of certain environmental, social, and governance (ESG) criteria used in socially responsible investing (SRI) practices. For instance, a company may decide to recycle water in its factories and replace its lighting with all LED bulbs. These undertakings have an immediate cost that may negatively impact traditional ROI—however, the net benefit to society and the environment could lead to a positive SROI.

There are several other new variations of ROIs that have been developed for particular purposes. Social media statistics ROI pinpoints the effectiveness of social media campaigns—for example how many clicks or likes are generated for a unit of effort. Similarly, marketing statistics ROI tries to identify the return attributable to advertising or marketing campaigns.

The Bottom Line

Return on investment is a metric that investors often use to evaluate the profitability of an investment or to compare returns across a number of investments. It is expressed as a percentage. ROI is limited in that it doesn't take into account the time frame, opportunity costs, or the effect of inflation on investment returns, which are all important factors to consider.