The goal of investing is to make money, so it's natural to pursue investments that offer the greatest possible return. Return on investment, or ROI, is a commonly used profitability ratio that measures the amount of return, or profit, an investment generates relative to its cost. ROI is expressed as a percentage and is extremely useful in evaluating individual investments or competing investment opportunities.
To calculate ROI, the profit (return) from an investment is divided by the cost of that investment, as shown in the following formula:
ROI = (gain from investment – cost of investment) / cost of investment
The result is then presented as a ratio or percentage.
Let's say you invest $2,000 in Company X's stock and sell your shares a year later for $3,000. To calculate your return on investment, you'd take your profit ($3,000 – $2,000 = $1,000) and divide it by your total investment cost ($2,000) to arrive at an ROI of 50%.
Uses of ROI
ROI is a helpful tool for comparing different investment opportunities. Companies also use projected ROI to determine which projects or initiatives to pursue based on their potential profitability.
Let's say you come into some money and are trying to choose a company to invest in. If you look at your portfolio and see that Company X gave you a return on investment of 50% but Company Y gave you an ROI of 60%, you may be more inclined to go with Company Y. In this regard, ROI is a strong measure of how efficient an investment is at generating profits.
Limitations of ROI
While looking at ROI is a great way to compare investment opportunities, ROI does not factor risk into the equation, especially in situations where ROI is calculated based on projected returns and not actual returns. In other words, ROI is a good way to measure what you potentially have to gain from an investment, but it doesn't necessarily tell you what you have to lose.
It's generally the case that the higher the return on investment, the more risk there is involved. Stocks, for example, have historically offered a higher return on investment than bonds, but they're also assumed to be more risky. Similarly, companies with lower credit ratings typically need to offer higher interest rates when issuing bonds than those with better credit ratings to compensate their investors for taking on added risk.
Let's say you decide to buy bonds issued by a company with a lower credit rating because those bonds offer a higher return on investment. While you might make more money from that investment than by buying bonds from a company with a higher credit rating and lower interest rate, buying the poorly rated company's bonds isn't necessarily the smarter investment decision -- because if that company defaults, you won't see those interest payments, and you won't actually realize that return.
In addition, the traditional formula for calculating ROI does not account for the amount of time an investment is held, which can impact its ultimate profitability. Furthermore, when used by companies in deciding whether to pursue projects, ROI doesn't account for the non-financial benefits involved. Project A, for example, might generate a higher return on investment than Project B, but Project B might also work wonders for a company's reputation -- a benefit that can't be measured financially. That's why ROI, though helpful in its own right, is just one calculation to consider when evaluating investment opportunities.
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