The business industry is not an easy one to grasp without the proper knowledge. It would be like writing a chemistry exam without any knowledge of the subject. It is very likely that you will fail without knowing what you are doing. If you go in with a good understanding of the mechanics, your chances of thriving are better. What’s more, you will be able to effectively utilize the tools and methods that accompany business practices.
Much like all other industries, this one comes with its own distinct set of terms. Once again, possessing knowledge of the industry’s functions are critical; this includes smaller ones that a single person owns. If you want to succeed in this cutthroat industry, it is imperative that you learn about these terms.
Among the array of terms – like ETFs and Black Swan Events – is ‘Return on Investment’, or ROI for short. This is a crucial analytical tool that a lot of businesses and investors frequently use in their operations. An easy way of explaining its function is that it’s a very special financial ratio. One that calculates the benefits that an investor will garner in relation to the cost of their investment. Put simply, it is a way to measure what you will receive in comparison to what you put in.
However, there is a lot more ground to cover to better explain the concept. On top of that, how you can find yours.
What is it?
‘Return on investment’ is a prominent financial metric of profitability. It is especially popular among those looking to measure an investment’s return or gain. Its popularity largely stems from its versatility and simplicity.
It gauges the overall efficiency of an investment. Alternatively, it compares the general efficiency of a specific number of different investments. ROI is an elementary ratio pertaining to the gain from an investment proportionate to its cost. It is very useful when it comes to evaluating the potential return from a stand-alone investment. Moreover, it is handy for comparing returns from various investments.
In business analysis, ROI among several of the key metrics, which also include other cash flow measures. Such measures are an internal rate of return (IRR) and net present value (NPV). ROI aids in calculating and ranking the overall appeal of a number of different investment alternatives. Basically, the higher the ratio, the greater the benefit.
Let’s imagine a hypothetical scenario to better illustrate it. Imagine that you are investing $100 in a share of stock. Now, imagine that its value suddenly rises to $110 by the end of the fiscal year. Taking that into account, the return on the investment becomes a healthy 10%. That is to say, assuming that there was no payment of any dividends.
ROCE: what’s the difference?
Before moving forward, we should shed some light on the similar-sounding ROCE measure. It shares some similarities with ROI, but it is ultimately its own metric.
ROCE stands for ‘Return on Capital Employed’ and it, like ROI, is a financial ratio. Its main function is to measure a company’s profitability and the efficiency with which its capital is used. Both ROI and ROCE are important profitability ratios that go beyond a company’s basic profit margins. Doing so allows them to provide a more in-depth assessment of how successfully a company runs its business. What’s more, how it returns value to investors.
Both measures are ideal in helping to determine the efficiency of how sufficiently a company utilizes its capital. There are significant differences between the two, though. For starters, ROCE is a more specific return measure than ROI. However, it is only beneficial when companies within the same industry use it. The numbers need to also cover the same period.
The ROI, unlike the ROCE, has more flexibility. It is a capable tool for comparing products, as well as projects and several investment opportunities. The main downfall when it comes to ROI is that it does not typically take time into account. An investment may have the same ROI, yet one can provide that return in a year. Meanwhile, a separate one can take a decade. In addition, the ROI calculation does not take fees or taxes into consideration. Both of which are very important for a company’s bottom line.
In order to properly calculate ROI, you must divide the benefit (or return) of an investment by the investment’s cost. The result is typically expressed as either a percentage or a ratio, though it is mostly the former. The calculation is straightforward and there are two methods in which one can calculate ROI.
The first method is the following:
ROI = Net Return on Investment / Cost of Investment x 100%
The second method is this:
ROI = Final Value of Investment – Initial Value of Investment / Cost of Investment x 100%
The first version of the ROI formula is arguably the one that is most commonly used. The easiest way to think about the ROI formula is by taking a “benefit” and dividing it by the “cost”. Whenever someone claims to have a good or bad ROI, there is something you should ask them. That being you need to clarify how exactly they measure it.
It would be smart for you to measure ROI on all your marketing efforts. That way you can make sure to spend your time and money on activities that will generate superior results. Be that as it may, you should also take ROI into consideration or benefits of any expenses that you have. Keep the following questions in mind:
- How many contributions will a newer and faster computer make for your business?
- Does the money you spend on a virtual assistant allow you to earn more than if you didn’t have it?
Furthermore, while financial investments have ROI as an attachment, it does not hurt to consider time as an investment. As you may recall, ROI not taking time into account is a huge drawback. So, you should remember to keep time in mind.
To continue the topic of keeping certain things in mind, there are some points to remember regarding ROI calculations:
- To reiterate an earlier point, the expression of ROI is mostly as a percentage and less as a ratio. As a percentage, it is intuitively easier to understand.
- The ROI calculation has ‘net return’ instead of ‘net profit or gains’ in the numerator. This is due to the fact that returns from an investment are regularly negative rather than positive.
- A positive ROI figure essentially means that net returns are in the black, as total returns surpass total costs. A negative ROI figure indicates that net returns are in the red as total costs exceed total returns. In other words, “in the red” means that this investment is generating a loss.
- To calculate ROI with even greater accuracy, one needs to take total returns and total costs into consideration. For a comparison between rival investments that is more ‘same class’, ROI on an annual basis should be considered.
Investopedia writer, Andrew Beattie, came up with a theoretical scenario about how one figures out their ROI. Suppose you are purchasing 1,000 shares of hypothetical Worldwide Wicket Co. and each is worth $10. Now, imagine if exactly one year later, you sell the shares for $12.50. You would earn dividends of $500 during the one-year holding period. You also spend a total of $125 on trading commissions when you were buying and selling the shares.
So, what is your ROI? Well, you can calculate this as the following:
ROI = [($12.50 – $10.00) x 1,000] + $500 – $125 x 100% / $10.00 x 1,000 = 28.75%
We now have the formula for the calculation. From here, let’s deconstruct it to see why it’s resulting in a 28.75% ROI in a step-by-step fashion.
- In order to calculate net returns, you must take total returns and total costs into consideration. The total returns for a stock ensue from both capital gains and dividends. Moreover, total costs would include the initial purchase price along with commissions that were paid.
- Take a look at the first term [($12.50 – $10.00) x 1,000]. As you can see, it displays the gross capital gain (i.e. before commissions) from this trade. The $500 amount is indicative of the dividends that you receive by holding the stock. Meanwhile, $125 is the total commission that is paid.
- Properly breaking the ROI down into its component parts will inevitably result in the following:
ROI = Capital Gains (23.75%) + DY (aka. Dividend Yield) (5.00%)
With all of this in mind, what exactly is the importance? The answer is the taxing of capital gains and dividends are at different rates in a majority of jurisdictions.
Alternative form of calculation
There is another way to calculate the ROI on your hypothetical Worldwide Wicket Co. investment. Suppose that the payment of the following split of the $125 is in total commissions. Specifically, $50 when buying the shares and $75 when selling the shares.
IVI = $10,000 + $50 = $10,050
FVI = $12,500 + $500 – $75 = $12,925
ROI = $12,925 – $10,050 / $10,050 x 100% = 28.60%
Keep in mind that IVI stands for ‘Initial Value of Investment’ (i.e. the cost of investment). Furthermore, FVI stands for ‘Final value of investment’.
The minor difference in the ROI values (28.75% vs. 28.60%) occurs for one particular reason. That being, in the second instance, the payment of the commission of $50 upon purchase of the shares was included in the investment’s initial cost. The numerator in both equations was exactly the same ($2,875). However, the slightly higher denominator in the second instance ($10,050 vs. $10,000) can slightly diminish the ROI figure.
Leverage is the outcome of using the capital you are borrowing as a funding source. Specifically, when you are investing to both expand the firm’s asset base and generate returns on risk capital. It is capable of magnifying losses should the investment wind up being a flop.
From the earlier example, we were making the assumption that you are buying 1,000 shares of Worldwide Wickets Co. Furthermore, you are purchasing them for $10 each. At this point, suppose you are buying these shares on a 50% margin. Basically, you will put up $5,000 of your capital and borrow $5,000 from your brokerage as a margin loan.
One year following this, you would go on to sell the shares for $12.50. You earn dividends of $500 throughout the holding period of one year. You would also spend a total of $125 on trading commissions when you buy and sell the shares. On top of that, your margin loan would carry an interest rate that equals out to 9%.
So, what will your ROI be? Before answering this, it’s important to mention that there are two notable differences between this and the earlier example:
- You should take the interest on the margin loan ($450) into consideration in total costs.
- Your initial investment is now $5,000 due to the leverage applied by taking the margin loan of $5,000.
Calculating with leverage
The total reduction of the net dollar return was by $450 mostly because of margin interest. However, ROI is substantially higher at 48.50%. This is especially noticeable when you compare it with 28.75% if there was no employment of leverage.
This raises an interesting question. Instead of increasing to $12.50, what if the share price were to fall to $8.00? Moreover, what if you had no other choice but to cut your losses and settle for selling the full position? ROI, in this particular case, would be the following:
ROI = [($8.00 – $10,000) x 1,000] + $500 – $125 – $450 / ($10.00 x 1,000) – ($10.00 x 500)
x 100% = -$2,075 / $5,000 = -41.50%
Therefore, ROI of -41.50% is worse than ROI of -16.25% that would have come from there is no leverage employment.
As you can imagine, using the ROI ratio provides an array of benefits. Several of them, among many others, are the following:
- It is simple and easy to calculate, as well as highly effective. There is a requirement of only two figures: the benefit and the cost. A “return” can mean different things to different people, so the ROI formula is simple to use. This is largely due to the fact that there is no concrete definition for “return.” This is arguably one of the most important benefits of using ROI for investment decisions
- For that matter, the calculation of the ROI is one of the easiest calculations to grasp financial ratios.
- The concept is universal. Since there is a worldwide understanding of this ratio, there is a guarantee that many people will understand what you’re referring to. The reason for this is that ROI is applicable in layman’s terms. This enhances the universally acceptable aspect of it in finances, investments, and business.
- It assists the investors and the financial professional in quickly checking the likelihood of investment. Thus, there is little to no instances of wasting time and money.
- The ratio helps in both exploring and measuring the potential returns on a variety of investment opportunities. This way, you can get a good idea of which one would be more preferable.
- It offers assistance with proper understanding and measuring the benefits of investment in certain departments.
- It aids in the measurement of the competition existing within the market.
Indeed the ratio is incredibly useful for important decisions pertaining to investments. While that may be true, there are a handful of noteworthy limitations to the ROI formula. These are important to be aware of so that you can fully understand what you may encounter. Below are some key points to keep in mind:
- As it has been mentioned before, ROI does not take time into consideration. A higher ROI number does not necessarily equate to a better investment option. For example, let’s imagine two investments that possess the same ROI of 50%. However, the first investment reaches completion in three years’ time. The second investment, on the other hand, needs five years to produce the same yield. The same ROI for both investments are blurring the bigger picture. With the addition of the factor of time, the investor will easily see the better option.
- The formula is vulnerable to manipulation. An ROI calculation will sometimes be different between two people. It largely depends on what ROI formula the parties use for the calculation. A marketing manager, for instance, can use a property calculation without taking additional costs into account. These could include maintenance costs, property taxes, sales fees, stamp duties, and legal costs. An investor, meanwhile, needs to look at the true ROI. This accounts for all possible costs that incur whenever each investment’s value experiences an increase
- Carrying over from the previous point, using different calculation processes of the ROI makes it confusing for different entities. A company may calculate with one specific formula, while the investor might calculate with a completely different one. Consequently, both a difference of opinion and utter confusion begin to emerge.
Challenges from social media
The difficulty when it comes to ROI calculation stems from how sufficiently revenues tie to a particular investment. Let’s use search engine optimization (SEO) as an example. If you use it, then it’s unlikely that you could accurately determine how much an SEO results in a revenue increase. This is because other factors like social media could also have a hand in a traffic increase.
Social media, most notably, can be quite difficult to measure. Be that as it may, there are some tools that can help. Facebook provides insights and an array of social media management tools, like Hootsuite, also supply analytics. Nevertheless, it can still be tricky to wholly know if clicks from social media lead to sales.
Furthermore, in most cases, customers and clients do not typically spend money on their first encounter with you. It’s conceivable that they will find you through a PPC (pay-per-click) ad and then follow you on social media. Following this, they will potentially sign up for your email list before ultimately buying. The main question to come from this is “which is responsible for the sale?” One could make the argument that the PPC is because it is what introduces the prospect. However, it is equally possible for an email or Tweet to result in the actual purchase.
In addition, the denominator would be zero because you are dividing by your expense. That is to say, it will be zero should you engage in a free promotional activity that results in a sale. Altogether, this would inevitably lead to a mathematical error.
Why is ‘return on investment’ so important?
With the in-depth explanation of the limitations pertaining to ROI, it would be easy to believe it’s not worth using. The drawbacks are evident, but that should not take away from the ratio’s significance and capabilities. To do so would diminish the benefits it brings to those who use it.
The advantages that can come from calculating ROI are difficult to ignore. It can help you better understand what is working and not working in your business. With this information, you have the insight you need to make proper changes. If your PPC ad is failing to generate a profit, then you are losing money. By understanding this, it will prompt you to do one of two things. Either you change the ad to improve ROI or you just ditch it altogether.
Overall, ROI is a helpful tool that earns its prominence in the field of investments. It is a straightforward and intuitive metric of profitability aiding in the measurement of investment returns and/or gains. Its versatility allows for the evaluation of the efficiency of a single stand-alone investment. Alternatively, it is ideal for comparing returns from numerous investments. Regardless of the limitations, ROI boasts widespread application.