Return on Investment (ROI) is a profitability measure that indicates the gain or loss made on investment as a percentage of the cost of the investment. This financial metric is used to assess the return generated by an investment as well as comparing returns across investments.
How is ROI calculated?
ROI in business and investing
Return on Investment evaluates the actual returns generated by an investment. It also helps in making investment decisions or building a portfolio, by evaluating expected returns based on projected or estimated value of investments.
– Let’s consider some basic investing examples to understand how ROI is calculated and used. Suppose an investor buys stock A for $1000 and sells it for $1200 after a year. In this case,
The same investor purchases stock B for $1100 and receives $100 in dividends during the holding period. The investor sells the stock for $1300. In this case the Net Profit on the investment = (1300+ 100-1100) = $300
Comparing the returns on the two investments, stock B generated a higher ROI for the investor. (Note: We used a simple example for explanation here. If we consider commissions paid for buying or selling securities, then such commissions should be subtracted when calculating Net Profit.)
– Businesses also use ROI to assess which investment or project may generate better returns. While making budgeting decisions, generally companies give priority to projects with a higher estimated ROI.
Limitations of the ROI measure
Return on Investment (ROI) is a widely used metric because of its simplicity. However, it has certain drawbacks.
– A major limitation of ROI is that it does not consider the holding period or time factor. Suppose an investment generates an ROI of 10% in one year, while another investment generates a return of 12% after three years, in this case choosing an investment without considering the time frame is not prudent. To consider different holding periods of investments and the concept of the time value of money, generally, Internal Rate of Return (IRR) is used. We can also use the Annualized ROI formula to consider the holding period of an investment.
Annualized ROI=[(1+ROI)^(1/n)-1]*100, n is the number of years of investment. If the holding period is less than one year then we can express the number of months as a fraction of a year, for example, in the case of 6 months, n=0.5.
So, the investment generating ROI of 12% in a period of three years has an Annualized ROI = [(1+0.12)^(1/3)-1]*100=3.85%
– Also, ROI only takes the return into account, without assessing other critical aspects such as the risk associated with the investment. An investment generating higher returns may be riskier compared to other potential investments. For instance, Bond A has a higher credit rating and offers ROI of 7% while Bond B has a lower credit rating with an ROI of 10%. Investing in Bond B only based on a higher ROI without considering the risk involved can be problematic.
– ROI does not take into account several non-financial aspects. For example, a project might generate higher returns but it may not comply with environmental regulations.
Can TipRanks help with choosing investments that consider ROI?
TipRanks offers various tools that can help you select stocks with attractive returns. For instance, the TipRanks’ Smart Score System helps investors find stocks with a high Smart Score. This unique score helps investors assess any stock. It takes into account 8 unique market factors including stocks ranked a “Buy” by the highest-ranked analysts, stocks that hedge funds have invested in, and other fundamental and technical factors. Another unique tool is the Analysts’ Top Stocks which displays top recommended stocks by the best performing analysts.
ROI is a very useful and easy-to-understand profitability measure that helps in evaluating individual investments, as well as comparing returns generated by various investments. However, a decision about a potential investment opportunity should not be solely based on ROI and should consider other factors such as time period and risk.