Saturday, February 7, 2015

Return on Investment or ROI

Return on Investment or ROI

Return on Investment or ROI is amount of profit or returns investors expect from their investments. All investors want to make a positive return or profit on the money they commit to their investments. In a nutshell, this is the basis behind the term “Return on Investment”, also known as ROI. ROI is mathematically defined as (gains-cost)/cost, and is usually expressed as a percentage. 

Before we delve into some of the nuances of ROI, lets look at a simple example. You have $1000 you wish to invest on a promising stock. You research your idea and decide to buy $1000 worth of shares. Time goes by and your idea is working out: the stock rises in price and you sell your shares, receiving $1500 from the sale. Your initial investment was $1000, and your profit (before taxes and commissions) was $500. In the example cited, your return on investment, therefore, was 1500 + 1000/1000, for a return of 0.5, or 50%, on your investment.

Return on Investment or ROI

ROI is used not only for stocks but for all kinds of investments and business endeavors. It is applied to investments in real estate, oil wells, collectibles, bonds, precious metals and any other form of investment.

As is often the case in the financial arena, there can be a number of factors to consider when calculating ROI, making some calculation more complicated than the simple example cited above. In the area of stocks and bonds, one would want to factor in dividends and interest received when calculating ROI. In the world of real estate, ROI calculations can become quite complex. The real estate investor must factor in rental income, appreciation, amortization, insurance and property upkeep.

Even collectibles, such as rare coins, paintings, and the like may have substantial maintenance costs, which need to be factored into ROI.

In some industries, Return of Capital Invested, or ROCI, is used instead of ROI. In the oil and gas industry for example, exploration and development expenditures are extremely high, and payoffs on investments may not be realized for many years. Hence ROCI is often used in businesses such as these instead of ROI.

Another metric related to ROI is Compound Annual Growth Rate, or CAGR. This is a calculation made to approximate the annual return on an investment that pays out over a number of years and at a variable rate. It is not a Return on Investment, but rather an attempt to show how an investment would grow over time if it grows at a steady rate.

A final nuance to consider is the role of leverage in investments. Many people buy stock on margin (a form of leverage) and most business finance their investments by borrowing (potentially another form of leverage). The effect of leverage should be incorporated in ROI calculations.

In summary, ROI is a very useful concept to keep in mind. It enables the investor to calculate how well an investment has performed. Consideration of likely outcomes for any investment can be viewed through the lens of the ROI calculation to help in the assessment of potential investments going forward.