Return on Investment (ROI) – Formula

ROI = Net Income / Cost of Investment

What is Return on Investment?

Return on investment (ROI) is a ratio used to calculate the benefit an investor will receive in relation to its investment cost, most commonly measured as net income divided by the original cost of the investment. The higher the ratio, the greater the benefit earned. This guide will break down the ROI formula and provides several examples of how to calculate return on investment.

ROI formula example

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ROI Formula

There are several versions of the ROI formula, which are all listed below:

ROI = Net Income / Cost of Investment

ROI = (Revenue – COGS) / COGS

ROI = Investment Gain / Investment Base

 

Example of ROI calculation

An investor purchases property A which is valued at $500,000; two years later, the investor sold the property for $1,000,000.

We use the investment gain formula in this case.

 

ROI = (1,000,000 – 500,000) / (500,000) = 1 or 100%

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The Use of ROI Calculation

ROI calculations are simple and help the investor decide whether to take or skip an investment opportunity. The calculation is a snapshot of how an investment has performed to date. When an investment shows a negative ROI, the investor doesn’t need to research it more.

Using an ROI calculation, the investor will separate low-performing investments from high-performing investments. This way, the investor can focus on the high performing investment choices only.

 

Limitations of ROI

 

#1 A Simple ROI Calculation Disregards the Factor of Time

A higher ROI number does not always mean a better investment option. For example, two investments have the same ROI of 50%; the first investment is completed in three years, while the second investment needs five years to produce the same yield. The same ROI for both investments blurred the bigger picture, but when the factor of time was added, an investor can easily see the better option.

The investor needs to compare two instruments under the same period and same circumstances.

 

#2 ROI Calculation Susceptible to Manipulation

An ROI calculation will differ between two people depending on what formula is used in the calculation. A marketing manager can use the property calculation explained in the example section without it accounting for additional costs, such as: maintenance costs, property taxes, sales fees, stamp duties, and legal and inspection cost.

When presented with different investment ROIs, the investor needs to take the true ROI, which accounts for all possible costs incurred when each investment increases in value, into consideration.

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