Return on investment or ROI measures how much money or profit is made on an investment as a percentage of the cost of the investment. ROI shows how effectively and efficiently investment dollars are being used to generate profits. Investors use ROI to determine how successful their investment is performing, but also in comparing their ROI with the performance of other investments.
Your ROI likely changes depending on what you are investing in and what you consider to be "favorable returns." For example, a company tracks the returns from a new marketing campaign differently than investors track returns in their investment portfolios.
However, it's safe to say that an investor cannot evaluate any investment's profitability, whether it's a stock, bond, rental property, collectible or option, without first understanding how to calculate return on investment (ROI).
The formula serves as the base from which all informed investment decisions are made, and although the calculation remains constant, there are unique variables that different types of investment bring to the equation. In this article, we'll cover the basics of ROI and some of the factors to consider when using it in your investment decisions.
How To Calculate ROI To calculate the profit on any investment, you would first take the total return on the investment and subtract the original cost of the investment. However, ROI is a profitability ratio meaning it gives us the profit on an investment represented in percentage terms. To calculate the percentage gain on an investment, we take the profit or net gain on the investment and divide it by the original cost.
Portfolio Example Of ROI Suppose you bought 200 shares of Bank of America Corporation (BAC) on June 5th, 2017 at the price of $22.12 for a total cost of $4,424.00. Following your purchase, bank stocks soared due to a strong economy and interest rate hikes by The Federal Reserve, ultimately boosting bank earnings. As a result, you decided to sell your shares of BAC on April 2nd, 2018 at a price of $29.31 for a total return of $5,862 and a profit of $1,438 ($5,862-4,424).
Your ROI for BAC would be 33% ($1,438/4,424). In this case, you would have done very well for yourself.
To take a more extreme case, the price of Apple stock was just over $5 per share in 2005, when the first iPhone was still in development. Ten years later and the price of Apple stock has skyrocketed to over $125 per share, for an amazing ROI of 2,400%, or 240% per year.
Comparing ROIs With Different Initial Investments Simply comparing the dollar value of gains between two investments doesn't provide a complete picture of the return on each investment. Since ROI is a ratio expressed as a percentage, it provides clarity as to the true gain on an investment.
For example, Diane and Sean both told you they had made profits on their investments. Diane made $100 from investing in options while Sean made $5,000 investing in real estate. With only the total dollar value of their profits available, we might assume that Sean's investment gain was the better of the two. However, without understanding the costs of each investment, we can't make an accurate conclusion about their returns.
For example, if Sean's cost was $400,000 and Diane's was only $50, Sean's ROI would be 1.25% while Diane's would be 200%. Of course, a $5,000 gain is far more than a $50 gain, but Sean's initial cost was far more than Diane's and, as a result, Sean was at risk for greater losses. The cost of the investment both initial and ongoing, are an essential piece of information for any investment. To learn more about ROI and other ways to value investments; please read our Financial Ratio Tutorial.
ROI Can Be Misrepresented The ROI calculation remains the same for every type of investment. The danger for investors comes in how costs and returns are accounted for. Here are some investments where their returns and subsequently their ROIs can be misrepresented.
Real estate can create returns in two ways, rental income and price appreciation. The investment return includes the rent collected and any price gains as the market value of the property rises. However, the costs of the investment come from many different sources including the initial purchase price, property taxes, insurance, and upkeep.
When we hear of people earning a 200% return from selling their home, they're often referring to the difference between the original purchase price and the selling price while omitting all of the costs over the years. For example, if it's an investment property, an investor might account for the rental income and price appreciation, but neglect to factor in the insurance costs, taxes and that new water heater.
Real estate can be a profitable investment, but the projected ROI on these investments can be exaggerated if all of the costs are not included.