If an investment doesn’t have a good ROI, or if an investor or business owner has other opportunities available with a higher ROI, then calculating the ROI values on the different opportunities can instruct them as to which investments to choose for the best return. Many analysts and investors like to use the ROI metric because of its versatility and simplicity. Essentially, it works as a quick gauge of an investment’s profitability, and it’s very easy to calculate and interpret for a wide variety of investment types. For investments in a company, you can find net income on the company’s income state and total assets from the company’s balance sheet. Here’s what that equation looks like: Investment gain (Net Income) / Cost of Investment (Total Assets) = ROI (%) If you’re investing in a security such as a company’s stock, you can use a slightly different ROI calculation that’s based on the buy and sell prices: Investment’s Price When You Sold It-Investment When You Bought It/ Investment Price When You Bought It = ROI (%)
Examples of ROI
Say that Joe invested $1,000 in his start-up, Joe’s Super Computer Repair. He has a buyer for the business for $1,200. The ROI for this equals Joe’s profit or $200 divided by his initial investment, $1000, for a 20% ROI. Joe also invested $1,000 in Sam’s New Computer Sales, and a buyer is looking to pay $1,800. The ROI for this equals the $800 profit divided by his investment of $1,000, or 40%. From this comparison, selling Sam’s New Computer Sales appears to be the wiser move because the return on investment is double what you’d get from Joe’s Super Computer Repair. Instead of buying a company, say you bought a company’s stock: 100 shares at $1 per share. Your initial investment was $100. Soon after buying the stock, the company’s CEO is arrested for fraud. The stock drops to 50 cents a share and you sell all your shares. Your ROI is -50%: (50-100)/100.
Interpreting ROI Results
To interpret the ROI percent results, collect appropriate, comparative data such as trend (time series) or industry data on ROI. The business owner can look at the company’s ROI across time and also at industry data to see where the company’s return on investment ratio lies.
ROI and the Time Factor
What the ROI formula doesn’t tell you, and one of the short-comings of the ROI ratio, is the time involved. This metric can be used in conjunction with the rate of return on an asset or project, which does consider the period of time. You can also incorporate the net present value (NPV), which accounts for differences in the value of money over time due to inflation, for even more precise ROI calculations. The application of NPV when calculating the rate of return is often called the real rate of return.
