Return on investment (ROI) is a financial metric used to evaluate the profitability of an investment. It measures the return or profits an investment generates relative to the capital invested. ROI is expressed as a percentage and can be calculated using the following formula:
ROI = (Gain from Investment – Cost of Investment) / Cost of Investment x 100%
In this formula, the “gain from investment” refers to the amount of money earned from the investment, while the “cost of investment” refers to the amount invested in the project. Let’s take a closer look at how to calculate ROI.
Step 1: Determine the Cost of Investment
The first step in calculating ROI is to determine the cost of investment. This includes all the expenses associated with the investment, such as the purchase price, transaction fees, and any other costs incurred in acquiring and holding the asset. For example, if you purchased a rental property for $500,000, the investment cost would be $500,000.
Step 2: Determine the Gain from Investment
The second step is to determine the gain from the investment. This includes all the income the investment generates, such as rental income, dividends, or capital gains. For example, if the rental property generated $50,000 in rental income and $100,000 in capital gains when it was sold, the gain from the investment would be $150,000.
Step 3: Calculate ROI
Once you have determined the cost of investment and the gain from investment, you can calculate the ROI using the formula above. In our example, the ROI would be:
ROI = ($150,000 – $500,000) / $500,000 x 100%
ROI = -70%
This indicates that the investment had a negative ROI of 70%, meaning that the investor lost 70% of their investment.
When interpreting ROI, it’s important to remember that a positive ROI indicates a profitable investment, while a negative ROI indicates an unprofitable investment. In addition, the ROI size can vary depending on the investment size, the length of the investment period, and the amount of return generated.
ROI can also be used to compare different investments to determine which is more profitable. However, it’s important to note that ROI does not consider other important factors, such as the level of risk associated with the investment, the time value of money, and the opportunity cost of not investing in other projects.
Calculating ROI is a critical aspect of evaluating the profitability of an investment. It involves determining the cost and gain from investment and then using a simple formula to calculate the ROI. While return on investment is a useful metric for comparing investments, it’s essential to consider other factors that may affect the profitability of an investment.