By Aniket Bose. Edited By Arjun Chandrasekar.
Overview
Return on investment (ROI) is a performance measure used to analyze the efficiency or profitability of an investment. ROIs are also used to compare the efficiency of a multitude of investments. ROI attempts to estimate the amount of return on a particular investment, relative to the investment’s cost. To calculate ROI, the benefit (or return) of an investment is divided by the principal amount of the investment. The result is either expressed as a ratio or as a percentage.
Understanding ROI
ROI is a popular metric because it is very versatile and simple to understand. Essentially, ROI can be used as a fundamental gauge of an investor’s profitability. This could be the ROI of a stock investment, where the ROI that a company expects on expanding a factory, or the ROI generated through a real estate transaction. The calculation for ROI itself is not too complicated and it is relatively easy to interpret its wide range of applications. If an investment’s ROI is net positive, then it is probably a worthwhile investment for the investor. However, if there are other opportunities with higher ROIs available, these signals can assist investors with eliminating or selecting the best investment for them.
Similarly, investors must try their best to avoid negative ROIs, which imply a net loss on the original investment. For instance, suppose Bill invested $1,000 in Domino’s in 2017 and decided to sell the shares for a total amount of $1,200 after one year. To calculate his return on this particular investment, we divide the net profits ($1,200-$1,000 = $200) by the investment cost ($1,000), resulting in a ROI of $200/$1,000 or 20%. This example of Bill’s investment has some limitations when it comes to using ROI, especially when comparing with other investments. ROI can be used in conjunction with the rate of return (RoR), which takes into account a project’s time frame. Investors may also use net present value (NPV), which is used for accounting for differences in the value of money over time because of inflation. The application of NPV when calculating the RoR is often called the real rate of return.
Developments in ROI
Recently, certain businesses and investors have taken an interest in the development of a new form of the ROI metric, known as “social return on investment” (SROI). SROI was initially developed during the late 1990s and takes into account broader impacts of projects using extra-financial value. SROI helps in understanding the value proposition of specific environmental social and governance (ESG) criteria that are used in socially responsible investing (SRI) practices. For example, a company may decide to recycle water in their factories and replace all of their lighting with LED light bulbs. These tasks are immediately associated with costs that may potentially hurt the traditional ROI. However, the net benefit to the society and environment could lead to a positive SROI. Several new forms of ROI have been developed for particular purposes throughout the world. Social media statistics of ROI pinpoint the effectiveness of social media campaigns, like how many clicks or likes are generated for a unit of effort. Similarly, marketing statistics of ROI attempt to identify the return owed to marketing or advertising campaigns. ROI relates to the amount of information learned and retained as a return on skills training or education. As the world continues to progress, develop, and change in the economy, there will be several other niche forms of ROI that are guaranteed to be developed in the unforeseen future.
Conclusion
Return on investment is a ratio between the net income of an investment and the original investment. A high ROI means the gains of the investment are compared favorably to the cost of the investment. ROI is a type of performance measure where it is used to evaluate the efficiency of an investment or to compare the efficiencies of different investments.
