When you make any investment, you want to ensure that it is well thought out and strategic. You also want any investment to provide a financial return, allowing your money to work for you. Understanding what return on investment (ROI) means can help you better evaluate the profitability of a business or investment.
ROI directly measures the amount of return on an investment. When you put money into an investment or business endeavor, determining your ROI helps you understand how much profit or loss your investment has or will potentially earn. Return on investment is a simple ratio that divides the net profit (or loss) from an investment by its cost. Because it is expressed as a percentage, you can compare the effectiveness or profitability of different investment choices. It is closely related to measures like Return on Asset (ROA) and Return on Equity (ROE).
In order to figure out our ROI, we need to know how to calculate it. First, divide the amount you earned from an investment; often called the net profit, or the cost of the investment; minus its value, or the cost of the investment; and multiply that by 100. The result should be represented as a percentage. Here are two ways to represent this formula:
ROI = (Net Profit / Cost of Investment) x 100
ROI = (Present Value – Cost of Investment / Cost of Investment) x 100
Let’s say you invested $5,000 in the company XYZ last year and sold your shares for $5,500 this week. Here is how you would calculate your ROI for this investment:
ROI = ($5,500 – $5,000 / $5,000) x 100
Your return on investment in company XYZ would be 10%. This simple example leaves out capital gains taxes or any fees involved in buying or selling the shares, but a more realistic calculation would factor those into the cost of the investment.
So why is knowing our ROI so important? It is a key performance indicator (KPI) that is often used by businesses to determine profitability of an expenditure. It is exceptionally useful for measuring success over time and taking the guesswork out of making future business decisions.
What is the bottom line? ROI is an understandable and easily calculated metric for determining the efficiency of an investment. This widely used calculation allows you to compare apples-to-apples among investment options. However, ROI cannot be the only metric investors use to make their decisions as it does not account for risk, and it requires an exact measure of all costs. Using ROI can be a good place to start evaluating any investment.
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