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In business, ROI is a term that refers to the gain from an investment after considering the cost. While many use the acronym to describe the benefit measure, it actually stands for Return on Investment.
If you would like to start your own business or you want to weigh the financial pros and cons of making a specific decision in your life, such as your college education, learning how Return on Investment is measured is important.
Read this guide and you can learn not only the formula to calculate the measure, but also when to use the formula and when it might not be effective.
What is the Return on Investment Formula?
The Return on Investment formula, which is also called the Rate of Return formula, uses the cost of the initial investment and the proceeds gained from that cost to measure the final return. The formula is as follows:
Rate of Return= [(Gain from Investment – Cost of Investment)]/ Cost of the Investment
This formula works because the Return on Investment is a percentage rather than just a specific amount of money. If you wanted to just look at the profits from an investment, you would simply subtract the cost of the investment from the proceeds earned.
Examples of Ways to Use Return on Investment
The use of the rate of return formula is most commonly used in finance and also in investing. Companies that want to use their revenues and implement the smartest investment strategies often compare different costs and projected gains before buying a stock or even before buying a commercial property. It is also common for angel investors to consider risk and return before making a decision or deciding how much of a company they want to own in exchange for an investment.
To really understand how this formula and measure can be useful, it could help to see a specific example. Jennifer purchases $1500 in stocks for Apple Inc. shares and then sells these shares for $3000 after the release of a new product. After subtracting the cost from the gain ($3000 – $1500) and dividing the result by the cost, you can see that there was a 100% ROI. If Jennifer also invested in a competing company and only profited by 40% in the same period of time, she can easily see which investment was best.
When Return on Investment Calculations Might Not Be Useful
In the example above, the formula only really works because comparisons are being made over the same period of time. If one investment profits by 100% over a period of a year and another profited by 40% over a longer span of 5 years, it is difficult to use the formula to measure which offers the best benefit. This is because investments can be more profitable during peak periods and may balance out over time. This is why investors need to consider the limitations whenever using investment measures.
There are several different measures that investors and business owners can use to decide where to allocate their capital and other financial resources. Some might even go as far to measure the return on their investment of time when deciding whether to go through with a project or certain training programs. While new forms of the metric are being implemented in a new business world, ROI is still a useful metric that can be used to measure benefits.
