What is Return on Investment and How is it Calculated?

Do you own any investments or have you ever owned any? How will you know whether or not your investment is/was profitable? When you invest in an investment such as stocks, real estate, or a business, the return on investment, or ROI, is necessary to help you understand how much profit or loss your investment has generated.

What exactly is ROI? Every investment offers financial gain, loss, or even break-even. The analysis of this financial performance, or return of investment (ROI), is a statistic used to understand the profitability of an investment. ROI allows you to assess the profit or loss from investment to determine its efficiency.

The following are two methods for calculating return on investment:

ROI = (Net Earnings ÷ Cost of Initial Investment) x 100

ROI = (Present Value – Cost of Initial Investment ÷ Cost of Initial Investment) x 100

So how does this formula work? Say, for example, you invested $1,000 in ABC company last 2018 and sold your shares for $1,200 in 2019. Here’s how you would calculate your ROI for the said investment:

ROI = 200 ÷ $1000 x 100

ROI = $1,200 - $1000 ÷ $1000 x 100

Another example, you also invested $2,000 in DEF company last 2015 and decided to sell your shares for a total of $2,800 in 2019. Given the formula, your ROI is at 40%.

ROI = 800 ÷ $2000 x 100

ROI = $2,800 - $2000 ÷ $2000 x 100

You can see that both of your investments at ABC and DEF companies had a positive ROI, one at 20% for one year and the other at 40% for four years. If you lost money on your investment, the ROI would be negative.

The calculation of ROI, as simple as it may appear, has its own set of limitations. Like the examples above, it ignores the investment's time horizon to generate a return, as well as any intermediate costs (such as brokerage) or benefits (e.g. dividends). You can't use only a simple ROI calculation to figure out which investment is the best, however, when reviewing your investment, the basic ROI calculation can be a good place to start.

12 views0 comments