Calculating return on investment is the most important way an investor can use to evaluate any class of investment, whether its bonds, stocks, option, collectible or rental property. This calculation forms a foundation where informed decisions regarding investments are made. Even though the calculations are constant, there are variables that each type of investment brings to the equation. We are going to cover the fundamentals of ROI in this article, and factors that an investor needs to consider when using it to make decisions on investment.
Understanding Return on Investment
The concept of how to calculate return on investment is very simple on paper. You simply need to take the profit of an investment, subtract the investment cost and then divide the total by the investment cost. ROI is normally expressed as a percentage and used ideally for personal financial decisions. It is used to compare the profitability of one company against another, or to compare the efficiency of different investment choices. ROI is a very practical formula to use, and that is why it is very common. It is very simple, and it is a useful methodology that anyone can use.
What Types of ROI’s Are There?
Total return can calculate the stock return over a month or 20 years. For instance, an investment of 10,000 in a stock, receives $400 in dividends when you owned it, and it finally grows to $10,700. The total return you have is $1,100, where $400 is in dividends and $700 in the appreciation of the stock.
When a company pays dividends, part of its value is transferred to the shareholders, therefore, the stock price becomes less, compared to when the company owned all the value. So, when considering the total return, remember to include the increase in stock price as well as the dividends received.
The percentage return represents the total return divided by the amount invested, and the result is multiplied by 100. For instance, $1,100 return on $10,000 translates to 11% return.
Average Annual Return
To calculate the average annual return, 1 is added to the percentage return as a decimal. The number is then raised to the power of 1 divided by the years the investment took. Finally, 1 is subtracted from the result and multiplied by 100. For instance, if you had 11% return that took 6 years, add 1 to 0.11 to get 1.11. Raise 1.11 to 1/6th power to get 1.0175. Then, subtract 1 and multiply by 100 to get the average annual return of 1.7%.
How to Calculate Return on Investment
Below you can see how to calculate the return on investment using a simple formula.
ROI = (Investment Gain – Investment Cost)/ Cost of Investment
Let us assume you want to invest in your friends coffee shop.
Investing in Samantha’s Coffee shop
If you purchase 30 shares of Samantha’s coffee for shop $15 a share, you have invested $450. If you sell the shares for $550, your ROI is ($550-450)/450 to get, 22%. Since ROI is measured as a percentage, you can easily compare it to returns from other classes of investments. This allows you to measure different types of investment against each other.
ROI can be used as a measure of the profitability of an investment. Simply put, if an investment has a negative ROI, or when an investor finds investing opportunities with higher ROI, then the values of ROI can help him choose the most viable investment.
For instance, if you had invested in Samantha’s coffee and profited with an ROI of 11%, you can compare the coffee shop’s profitability to other investments. If you had invested $12,000 in a Car Wash Company in 2011 and sold your shares for a total of $18,000 in 2017, your ROI would be 50%. Your profitability from the Car wash is 5 times more than the Coffee shop’s ROI. It would seem that the Car Wash investment was a better one.
Applications of Return on Investment
ROI formula can be used to compute a company’s ROI by dividing the net incomes by the equity of the owners. This will help in measuring how the company is using the equity that has been invested in it. You can calculate a company’s profitability and compare it to the other competitors.
ROI can also be computed for different product lines, divisions or profit parts in a small business. This gives the management a point to compare the performance of different components. A division may generate higher profits than the other, causing the management to invest more resources in it.
How to calculate return on investment can also help in the evaluation of an investment proposal into new equipment. This can be done by dividing the profit increase to the equipment by the investment capital increase required to purchase it. For instance, a small business may save $10,000 in operating costs by spending $30,000 on one equipment. This results in an ROI return of $10,000/$30,000 or 33%. If the company’s cost of capital before the investment is lower than this figure, and there are non-investment opportunities for this funds, purchasing the equipment could be a better decision.
Practical Example of Knowing Return on Investment
Jonathan is a small country boy who decided to earn some money for his summer vacation. To achieve this, he decide to start a small lemonade stand. In this example, we will show you how to calculate return on investment for a project.
On his expenses, he had the following items:
- Pens, cardboard, and creativity for advertising: $20;
- Portable chair and table and coolers that he borrowed from his parents: $0.00;
- 4 dozens of lemons: $60;
- 400 paper cups that are eco-friendly: $120;
- 15 liters of ice cubes that are made from home: $20;
- 3 pounds of sugar: $6;
- 60 liter of mineral water: $ 120;
Total expenses: $ 346.00
It is possible to produce approximately 75 liters of lemon juice as ice works to increase the quantity. Jonathan can get 290 paper cups of lemon juice selling at $2 a piece. This translates to a revenue of $580.
If Jonathan sells 30 paper cups a day, within ten days, he will have achieved his goal. Now, to put ROI to work, Jonathan will get an ROI of:
ROI=(580-346)/346 x 100
This means that each $1 invested, Jonathan gains approximately 0.67 cents. We can also say that for each dollar invested, Jonathan completes his venture with $1.67. This is an enlightening way of working a business’ Return on Investment.
How to calculate return on investment is important when measuring any investment; it is one sure way to help in making any investment decision. It is a simple way to identify which division or product is worth investing in, and which product line should be cut short. Investing becomes way easier with ROI because of the comparative nature it allows one to make different investment choices.
What do you think about ROI as it applies to your business? What do you think about how to calculate return on investment in your business or project? Does your company employ other forms of investment analysis? Tell us your take on ROI; feel free to add your comments.
Recommended read: How to Calculate Compound Annual Growth Rate (CAGR)