Return On Investment (ROI)

Return on Investment (ROI) is a performance measure used to evaluate the efficiency or profitability of an investment or compare the efficiency of several different investments. ROI calculates the return of an investment relative to its cost.

Formula

The formula for ROI is:

$$ROI=\frac{\text{Net Profit from the Investment}-\text{Cost of the Investment}}{\text{Cost of the Investment}}\times 100\mathrm{\%}$$

Components

1. Net Profit from the Investment: This is the total amount of money earned from the investment minus any costs directly related to the investment itself.

2. Cost of the Investment: The total amount of money spent to acquire or invest in the asset.

Strengths

• Provides a straightforward percentage-based metric to assess an investment's profitability.
• Can be used for a broad range of investment types and scenarios.
• Helps in comparing the profitability of different investments, making it a versatile tool for decision-making.

Limitations

• ROI is a historical measure, which means it's based on past performance. Past performance might not always be indicative of future results.
• It doesn't consider the time value of money.
• Does not take into account the holding period of the investment. Two investments might have the same ROI, but different holding periods.

Example

Imagine a company spends $200,000 on a marketing campaign and sees an increase in profits of $300,000 attributable to this campaign. The ROI would be:

$$ROI=\frac{\text{\$300,000 - \$200,000}}{\text{\$200,000}}\times 100\mathrm{\%}=50\mathrm{\%}$$

This means that for every dollar invested in the campaign, there was a return of $1.50 (the original dollar plus 50 cents profit).

Quiz

Loading...