What is Return on Investment (ROI)?

Getting a return on investment is like growing potatoes…

By choosing to plant one potato rather than eating it, you are hoping it will grow into more than one. If your spud (investment) grows into five, your patience is rewarded with a 400% ROI. Of course, your potato could take a long time to grow, or might not sprout at all. So don’t forget to consider the risk.

When you invest in something — whether it’s a stock, bond, real estate, small business, or anything else — you’ll eventually want to get that money back, plus more. The “plus more” part — what you get above what you put in — is profit. Looking at profit as a percentage of the money you contributed is your return on your investment. ROI is a common metric for conveying the profitability of an investment. You can use it to determine the value of buying real estate, investing in a company, or even giving money to charity. Companies can use ROI to evaluate the value of introducing a new product line, expanding a factory, opening a new location, buying out a competitor, launching a marketing campaign, or embarking on a new training program. The metric has also come in handy to support public policy initiatives, research programs, medical procedures, and more.

ROI shows how much you gained or lost relative to the size of your total investment, almost always presented as a percentage. ROI puts different investments on a level playing field, allowing you to size them up in a standardized way. That can help you figure out which opportunities to pursue or which assets in your portfolio to sell.

There is technically no limit to how high ROI can be. On the other hand, no investment can guarantee a return. A negative ROI implies that you did not get all of your initial investment back. The worst possible ROI would be a total loss of your investment, which would be -100%. A ROI of 0% means you got your money back, but nothing more.

To determine your return on investment, divide the net change in the value of the asset by its price. Then, multiply that number by 100 to put the ratio in percentage terms.

ROI = (Net Profit / Total Cost of Investment) x 100

Net profit is the difference between the original cost of the investment and its value when you sell it, accounting for any associated costs. So an expanded version of the formula looks like this:

ROI = ((Value of Investment - Cost of Investment – Associated Costs) / Cost of Investment) x 100

For example, let’s say you purchase 100 shares of Make Believe Company for $10 a share, for a total purchase price of $1,000. When you sell those shares, they are worth $14 each, for a total payday of $1,400, Let’s also assume you paid a $5 commission on each trade, so $10 in associated costs. Here’s how you would calculate ROI:

ROI = (($1,400 - $1,000 - $10) / $1,000) x 100 = 39%

Any positive number can be considered a “good” return on investment — It means you got your money back and then some. But ideally, a desirable ROI should be better than your next best alternative.

People often compare a potential investment to putting their money in the broader stock market. Over the past four decades, the average annual return of the S&P 500 (an index of 500 companies traded on the stock market) has been close to 7%, after inflation. While past performance does not guarantee future results, a good ROI may be one that beats the stock market in the long term. Alternatively, you could put your money in a high-yield savings account. As of November 2019, some of those come with an annual percentage yield of more than 2% and no risk. If the investment you are considering doesn’t beat the ROI of your other options, it’s probably not a good option for you.

However, there is a well-established relationship in investing between the level of risk and potential rewards. So an investment promising a very high ROI probably comes with a greater chance of losing your money. Meanwhile, a low-risk opportunity will likely have a lower ROI. Either of these could be considered a good investment, relative to the risk they represent. For this reason, a good ROI depends on the risk level of the investment, your goals, and your risk tolerance.

One significant limitation of the return on investment metric is that it doesn’t account for how long it takes to make the return. For example, say Investment A is a $100 bond that matures in five years, with a value at maturity of $125. Investment B is a $500 loan for which you’ll receive 12 monthly payments of $50. And Investment C is a $200,000 property that you expect to sell for $275,000 in 10 years.

If these investments all work out as planned, your expected profit opportunities look like this:

• Investment A = $25
• Investment B = $100
• Investment C = $75,000

Translating that to ROI looks like this:

• Investment A = 25%
• Investment B = 20%
• Investment C = 38%

But accounting for the timing of those profits (by dividing the total ROI by the number of years you must hold them) creates an annual average ROI of:

• Investment A = 5%
• Investment B = 20%
• Investment C = 4%

Clearly, ROI doesn’t tell the full story once you take time into account. ROI also doesn’t account for risk. Perhaps that bond is much more likely to generate returns than the loan, which may not be paid off on time. Growth in real estate value is never a sure thing. And losing $100 is a lot less painful than losing $200,000 for most of us. All of these factors play a significant role in deciding which investment to make.

Another limitation is that ROI is sensitive to changes to the inputs. Take this example:

You purchase an asset for $10,000. The broker charges a commission of $200 on the deal. A few years later, you sell the asset for $12,500. The broker fee costs you $250 on the sale.The ROI on this investment depends on where you include those fees. If you consider the original cost to include the broker fee, the ROI is 20.1% [($12,500 – $10,000 - $450) / $10,200]. But if you only count the purchase price, without the commission, the ROI increases to 20.5% [($12,500 – $10,000 - $450) / $10,000].

Similarly, a simple ROI calculation may neglect some associated costs. Perhaps a real estate investment has unexpected maintenance expenses, a loan has an annual escrow fee, or there are special taxes levied on gains from a particular type of investment. If you don’t deduct these expenses from the final value, intentionally or inadvertently, ROI can hugely overstate how attractive an opportunity is.

Since return on investment doesn’t account for how long you hold on to an asset, it’s essential to compare the ROI of investments over the same period. When that’s not possible, there are a few other options.

For one, you can adjust the ROI for the timing of the earnings. Dividing the ROI by the number of years the asset was owned (as in the example above) would get you the annualized return on investment or average annual return. A more accurate (and complicated) approach is calculating the compound annual growth rate (CAGR) of investments. This method captures the effects of compound interest over time — or interest you make on interest earned previously.

Another alternative to ROI is to calculate the internal rate of return (IRR). This equation takes into consideration that a return received earlier is worth more than the same return received later, all things being equal. That’s because that money could have been saved or invested during that time, earning interest, and because money generally loses value over time due to inflation. However, this equation doesn’t take into account inflation directly. Calculating IRR is somewhat complicated, but several online calculators exist that can help.

Some of the earnings from any investment come from the fact that the price of everything tends to rise over time — This phenomenon is called inflation. You may want to know how much of your annual returns come from the investment itself, and not from inflation. To do that, you can calculate the “real rate of return”:

Real Rate of Return = (1 + Nominal Rate)/(1+Inflation Rate) - 1

The nominal rate is the return you expect to get not adjusted for inflation.