Investment has an ever-evolving scenery. This extremely dynamic nature requires a proper understanding of the basic rules. Understanding these basic rules includes knowing the different types of investments and determining the return from each.
Returns on Investment (ROI) is the ratio between net profit and the cost of an investment. The higher the ratio, the higher the profit is, compared to the cost incurred in investment. It is a performance measurement used to determine the amount of investment. The result is expressed in percentage or as a ratio.
To calculate ROI, the Cost of Investment is first subtracted from the Current Value of Investment. The result of the first calculation is the Net Profit on the Investment. The Net Profit on the Investment is finally divided by the Cost of Investment to get the ROI. It is measured in percentage so that it can be easily compared to other investments.
It is considered very simple, especially for calculating the profitability of an investment. As you can see above, the calculation is not complicated. There are times when the ROI is negative. It shows a net loss on investment. A positive ROI, on the other hand, is a sign of a profiting investment. Comparing different ROI results helps investors eliminate the less profiting options and select the much better ones.
It can be used to analyze ROI in different investments such as ROI on a stock investment, ROI on the company’s expansion, or ROI in a real estate transaction. However, ROI has a major limitation, which is not accounting for an investment’s time frame.
For example, I made an investment of $5000 on a particular stock in 2010. If I sold it for $5250 in 2011. My profit is ($5250-$5000 = $250) and ROI is ($250/$5000 = 1:20 or 5%). My friend also invested $4000 on the same share of stock in 2010. She sold her share of the stock for $4400 in 2012. That means, her profit is ($4400-$4000 = $400) and ROI is ($400/$4000 = 1:10 or 10%).
By using the example above, my friend’s ROI is higher than mine. Her stock’s profit doubled its first-year profit during the second year. Hence, ROI is often used together with the Rate of Return. There is also Net Present Value (NPV). These tools help to calculate the Real Rate of Return. Return on Integration is also used. It values financial returns based on both its long term situation and social influence.
As an investor, you must not forget that your return is not all yours. Not to worry, it is still yours as soon as you remove taxes and other investing fees.