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What is Return on Investment?

4 Mins 21 Mar 2023 0 COMMENT

Investing is the ideal way to improve financial standing and achieve various goals for both individuals and businesses. There are different types of investments to make. Before venturing into any investment, you must consider its profitability and efficiency. This helps you choose the right investment options and subsequently gauge the returns you will reap from them. This facilitates better financial planning as well.

A simple and effective way to determine an investment’s profitability is using the financial metric called Return on Investment (ROI). The article offers basic yet essential pointers about the financial metric you should be aware of.

Return on Investment

As the name suggests, Return on Investment is a financial metric that helps determine the returns you will reap, relative to the cost of investment. It is typically expressed as a percentage and can be readily used by both individuals and businesses.

Calculating the ROI is very simple. All you need to do is divide the total investment returns, popularly known as the net income, by the total investment cost and multiply it by 100. Alternatively, you can divide the subtracted amount of the investment’s present value from the total investment cost by the total investment cost and multiply it by 100.

The Return-on-Investment formula can be expressed as follows:

• ROI = (Net profit/ investment cost) x 100
• ROI = {(Present value – investment cost)/ investment cost} x 100

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Why is ROI such a popular financial metric?

ROI to date continues to be the most widely used financial metric to evaluate an investment’s profitability. Following are the various benefits of using ROI, that make it so popular:

• You can use ROI to gauge the profitability of all kinds of financial investments. You can use it to determine your returns from fixed-income investments, equities, and real estate. Businesses can use it to determine the efficiency of investing in various projects like marketing and advertising.
• ROI helps you draw comparisons and opt for the right investment option. This is possible as ROI is expressed as a percentage.

Let’s understand how ROI helps you draw comparisons better, by using the below example.

Let’s say you have invested Rs 2,000 in the shares of Company A and Rs 10,000 in the shares of Company B. After the end of one year period, your investment in the shares of Company A spiked to Rs 5,000 while the investment in Company B reaped you Rs 20,000.

With the help of the ROI formula, you can calculate that the investment in A will have an ROI of 150%, while the investment in B will have an ROI of 100%. This clearly shows that investing in the Company A was a better choice.

What to be mindful of when calculating ROI?

• Consider the total value

When calculating ROI maximum number of people tend to take the initial and final investment value for calculation. However, that shouldn’t be the case. You should consider the various costs and gains associated with the investment throughout its lifetime.

For instance, with equity investments, most people do not include transaction costs and dividend payments in their total investment cost. This leads to inaccurate calculations. A similar logic applies to real estate investments. You must include maintenance cost, rental income, tax benefits, and insurance in the total investment cost for the calculation of ROI.

• Opt for annualised ROI

A limitation of the ROI formula is that it does not take time into account. This often acts as a hindrance in drawing suitable comparisons. For instance, again there are two investment options – A and B. The A investment option has an ROI of 20%, while the B investment option has an ROI of 15%.  Considering the ROI, you will think A is a better investment option.

However, the time the investment takes to earn these returns is not considered. Option A could take five years, while option B would take three years to reap you returns. Hence, the time horizon is something to be mindful of.

The way around this limitation is by using annualised ROI rate. You can obtain an investment’s annualised ROI rate by using the following formula:

Annualised ROI = { [ 1 + ( Net profit / cost of investment) ] ( 1/n ) – 1 } x 100

• Make note of all aspects

Another drawback of ROI is that it does not consider non-financial aspects of any investment. For instance, it does not consider the associated risk and tax benefits. These things make a significant difference in the profitability and efficiency of an investment. Have a thorough understanding and consider all aspects before venturing into any investment.

Return on Investment is a valuable financial metric, that helps you assess the profitability of investments. make informed investment decisions. It is essential to ensure the accuracy of data when calculating ROI, to ensure informed investment decisions are made. An online ROI calculator can be used to simplify and expedite the process, providing an estimated return from investments in a matter of seconds.

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