What is return on investment (ROI)?

What is ROI and why do we use it?

Return on investment (ROI) is a profitability ratio commonly used in finance to calculate an investment's return or profit relative to its cost. 

Expressed as a percentage, ROI is handy in comparing the performance of assets or competing investment opportunities. 

Put simply, ROI is a ratio between net profit and investment cost. A good ROI means the investment's gains compare favourably to its price. 

Calculating ROI

To calculate return on investment (ROI) in its most straightforward form, you only need to consider how much you initially spent on the investment and how much you've earned from it. Here's how you can work it out:

ROI (%) = Current investment value − initial investment value × 100% / initial investment value

By multiplying the ratio by 100, we convert it into a percentage. This reveals the percentage of the initial investment recouped over time.

The current investment value is simply the revenue from the sale of the investment. For example, an investor purchases property A, valued at $500,000. A year later, the investor sells the property for $700,000.

So, the ROI formula in this case would be:

ROI = ($700,000 – $500,000) x 100 / ($500,000) = 40%

An ROI calculator divides the total value by the total cost to determine the ROI percentage.

Understanding ROI

The ROI calculation is relatively easy to interpret for a range of ventures and investments. 

For example, suppose Jill invested $1,000 in Tip Top Transport Corp in 2020 and sold her shares for $1,200 after one year. To calculate the return on her investment, she would divide her profits ($1,200 – $1,000 = $200) by the investment cost ($1,000) for an ROI of $200/$1,000, or 20%.

Jill could use the ROI metric to compare her investment in Tip Top Transport with her other projects. Perhaps Jill also invested $2,000 in Big-Save Stores in 2018 and sold her shares for $2,800 in 2021. The ROI on Jill's holdings in Big-Save would be $800/$2,000, or 40%.

Jill's examples show that her investments had a positive ROI. If her investments lost money, this metric would be negative.

ROI is a straightforward measure for investors to gauge the profit made from their investments. It's possible to analyse ROI for both existing investments and those being considered, as well as for specific business scenarios. Since we express ROI as a percentage, it simplifies comparing the returns from various assets.

Are there limitations to ROI?

While generally helpful, there are some shortcomings to the ROI equation. Examples like Jill's reveal some limitations when weighing up performance over different time periods.

In the above example, the ROI of Jill's second investment is that of double her first investment, but the time between purchase and sale is one year for her first investment and three years for her second. A higher ROI is a less meaningful comparison when we have calculated two investment figures over different time periods. 

Jill could annualise the ROI of her second investment for a better analysis. The total ROI is 40%, so she could divide this by three to calculate an annual average ROI of 13.33%. With this adjustment, you can see that while Jill's second investment earned more profit overall, her first investment was more efficient.

Additionally, the simplest form of ROI merely calculates the difference in the asset's value over time. When investing in any asset, you also have to account for the costs of the investment, plus the tax implications, to get an accurate picture of your investment returns.  

How to maximise your portfolio's ROI

Your aim as an investor is to maximise the ROI of your portfolio. But you can't control the inputs to the ROI metric. Share prices fluctuate over time, and no matter how much you believe in the shares you buy today, you can't predict what the share market will do in future. 

There are, however, some steps you can take to try and maximise your portfolio's ROI, which we have outlined here: 

1. Invest consistently 

This means making regular contributions when you can, whether in bear or bull markets. Although it can feel counterproductive to contribute to your portfolio when share prices are falling, you can buy more shares when they are selling at a lower price. 

When the market picks up (as it inevitably does), you should make serious gains on those shares you invested in when the market was in the doldrums. 

2. Diversify your portfolio 

There is a reason seasoned investors talk about diversification – not only can it minimise risk, but it can also help maximise ROI. Diversifying your portfolio means investing across different industries, companies, and countries. 

Think about it this way — if you invest only in one sector, say retail, you are 100 per cent exposed to the performance of that sector. Your portfolio could be crushed if there was a market crash or correction. 

However, volatility does not impact all sectors at the same time or in the same way. You can hedge risk by having a range of investments.

3. Keep your long-term goals in mind

Many investors dream of getting rich quickly. Engaging in risky strategies to pursue this can be tempting, but they can ultimately backfire. Few investors will see a massive increase in their portfolio value over a short period. 

Rather than trying to get rich quickly, focus on your longer-term financial goals and what you can do daily to build towards them. In investing, time can be your friend as it allows for returns to compound. 

Developments in ROI

New types of ROI measurements have emerged over time. Traditional ROI measures the financial return of an investment. However, as it becomes essential for organisations to look at social and environmental impacts, a new way of measuring ROI has arisen. It's called the 'social return on investment' or SROI. 

SROI gives monetary value to specific environmental, social, and corporate governance (ESG) criteria used in socially responsible investing (SRI). 

For instance, a company may replace its office lighting with LED bulbs or implement wastewater recycling in its factories. These expenses have an immediate cost, which may negatively impact traditional ROI. However, the net benefit to society and the environment could lead to a positive SROI.

While new niche forms of ROI may appear, we can't always measure some outcomes and impacts with a monetary value. Factors such as cash flow, net income generated by assets, and profit margin will significantly affect ROI calculations. The ROI of invested capital will ultimately depend on the future cash flow it generates.