Return on investment (ROI), or simply ROI, is a profitability ratio that measures the gain or loss generated from an investment, according to the amount of money invested.
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The ROI ratio offers a company insight into how profitable a potential project or investment will be, by measuring how much the company will get back compared to what they invest. ROI is used for comparing the profitability of the company with the capital available on the asset side.
What is the ROI formula?
The ROI ratio is usually expressed as a ratio or percentage and is calculated by taking the net gains and net costs of an investment (x100 for percentage). A higher ROI percentage indicates that the investment gains of a project are favourable to their costs.
For Example:
- Ben’s company initially invested £500 in a project (investment cost)
- The project is now worth £700 (investment gain)
Ben’s ROI ratio for this project would be calculated by subtracting the investment cost from the investment gain, and dividing by the initial investment cost:
(£700-£500) / (£500) = 0.4
- The ROI percentage is therefore 0.4 x 100 = 40%This is considered a high ROI percentage and indicates that regarding the investment costs of the project, Ben is receiving a 40% return in capital gains.
What does the ROI indicate?
ROI takes an investment view, and is typically used for financial decisions where a company can compare different projects and the effectiveness of the different investments. It is an indication to the investor of the holistic growth of an investment from start to finish, by taking the cash flow streams following an action. What makes ROI so popular is that it provides an easy and direct method to compare net gains to costs of an investment.
The ROI measures how well an investment performs and whether a company is using their resources in an efficient way, by telling investors how much profit each pound invested into that project is producing.
What are the limitations of ROI?
ROI can be misleading in cases such as evaluating long-term investment returns, since it does not account for the time value of money. The simple ROI method is more commonly used for short-term investments, and can often be less accurate when calculating an ROI for long-term investments.
Although the ROI percentage of an investment may be high, this might not necessarily be as profitable for a 20-year investment as it would for a 5-year investment. And similarly, if the ROI is negative in the first year it does not directly indicate a bad investment, since the ROI percentage could increase over the following years, becoming positive. Hence, a pound today is not worth the same as a pound tomorrow.
Discounted ROI method
To account for the time value of money, a more accurate ROI measure for long-term investments is the discounted ROI formula. The discounted ROI indicates the net present value of gains (ROI) divided by the net present value of costs. The discounted ROI method therefore takes into account the present value of future cash flows, allowing for future cash flows to be comparable to current cash flows.
The present value of future cash flows is calculated by multiplying the cash flow by a discount rate. Consequently, the higher the discount rate the lower the present value of future cash flows.
