What Does Return On Investment - ROI Mean?

A performance measure used to evaluate the efficiency of an investment or to compare

the efficiency of a number of different investments. To calculate ROI, the benefit (return)
of an investment is divided by the cost of the investment; the result is expressed as a
percentage or a ratio.

The return on investment formula:

In the above formula "gains from investment", refers to the proceeds obtained from
selling the investment of interest. Return on investment is a very popular metric because
of its versatility and simplicity. That is, if an investment does not have a positive ROI, or
if there are other opportunities with a higher ROI, then the investment should be not be
undertaken.

Return on investment is frequently derived as the “return” (incremental gain) from an

action divided by the cost of that action. That is “simple ROI,” as used in business case
analysis and other forms of cash flow analysis. For example, what is the ROI for a new
marketing program that is expected to cost $500,000 over the next five years and deliver
an additional $700,000 in increased profits during the same time?

Simple ROI is the most frequently used form of ROI and the most easily
understood. With simple ROI, incremental gains from the investment are divided by
investment costs.

Simple ROI works well when both the gains and the costs of an investment are easily
known and where they clearly result from the action. In complex business settings,
however, it is not always easy to match specific returns (such as increased profits) with
the specific costs that bring them (such as the costs of a marketing program), and this
makes ROI less trustworthy as a guide for decision support. Simple ROI also becomes
less trustworthy as a useful metric when the cost figures include allocated or indirect
costs, which are probably not caused directly by the action or the investment.
The ROI Concept
Most forms of ROI analysis compare investment returns and costs by constructing a ratio,
or percentage. In most ROI methods, an ROI ratio greater than 0.00 (or a percentage
greater than 0%) means the investment returns more than its cost. When potential
investments compete for funds, and when other factors between the choices are truly
equal, the investment—or action, or business case scenario—with the higher ROI is
considered the better choice, or the better business decision.

One serious problem with using ROI as the sole basis for decision making, is that ROI by
itself says nothing about the likelihood that expected returns and costs will appear as
predicted. ROI by itself, that is, says nothing about the risk of an investment. ROI simply
shows how returns compare to costs if the action or investment brings the results hoped
for. (The same is also true of other financial metrics, such as Net Present Value, or
Internal Rate of Return). For that reason, a good business case or a good investment
analysis will also measure the probabilities of different ROI outcomes, and wise decision
makers will consider both the ROI magnitude and the risks that go with it.

Decision makers will also expect practical suggestions from the ROI analyst, on ways to
improve ROI by reducing costs, increasing gains, or accelerating gains (see the figure
above).
opedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Copyright © 2011. Marty J.Schmidt.
competing Investments: ROI From Cash Flow Streams
ROI and other financial metrics that take an investment view of an action or investment
compare investment returns to investment costs. However each of the major investment
metrics (ROI, internal rate of return IRR, net present value NPV, and payback period),
approaches the comparison differently, and each carries a different message. This section
illustrates ROI calculation from a cash flow stream for two competing investments, and
the next section ( ROI vs. NPV, IRR, and Payback Period) compares the differing and
sometimes conflicting messages from different financial metrics.

Consider two five-year investments competing for funding, Investment A and Investment
B. Which is the better business decision? Analysts will look first at the net cash flow
streams from each investment. The net cash flow data and comparison graph appear
below.

Year Year Year Year Year

Total
Now 1 2 3 4 5
Net
Cash
–100 20 30 40 70 80 140
Flow
A
Net
Cash –
70 60 40 30 20 120
Flow 100
B

Two aspects of the data are apparent at once: (1) Investment A has the greater overall net
cash flow for the five year period, but (2) the timing of cash flows in each case is quite
different. The differences in timing are even more apparent in a graphical representation
of net cash flow:
 To answer the question, "Which is the
better business decision for the company?" the analyst will want to examine both
investments with several financial metrics, including ROI, NPV, IRR, and Payback
period.

In order to calculate ROI, the analyst needs to see both cash inflows and outflows for
each period (year) as well as the net cash flow. The tables below show these figures for
each investment, including also cumulative cash flow and Simple ROI for the investment
at the end of each year.

Investment Year Year Year

Now Year 1 Year 5 Total
A 2 3 4
Cash
0 40 50 95 105 355
Inflows A 75
Cash
100 20 20 35 25 25 225
Outflows A
Net Cash
–100 20 30 40 70 80 140
Flow A
Cumulative
–100 –80 –50 –10 60 140
CF A
Simple ROI - – – –
62.2%
A 100.0% 66.7% 35.7% 5.7% 30.0%

For Investment B...

Investment Year Year Year

Now Year 2 Year 5 Total
B 1 3 4
Cash
0 100 90 50 40 355
Inflows B 75
 Cash
100 30 30 35 20 20 235
Outflows B
Net Cash
–100 70 60 40 30 20 120
Flow B
Cumulative
–100 –30 30 70 100 120
CF B
Simple ROI - –
18.8% 51.1%
B 100.0% 23.1% 35.9% 46.5%

Simple ROI for each investment, in each period is shown in the bottom row of each
table. Applying the cash flow ROI formula above to these data, the ROI for, say, Year 3
of Investment B is given as

Using simple ROI as the sole decision criterion, which investment is the better business
decision? The answer here is: that depends on the time period in view.

• Considering the 3-year ROIs from each investment, clearly B's ROI of 35.9% is
better than A's ROI of –5.7%.
• Considering the 5-year ROIs however, investment A clearly has the higher ROI at
62.2%, vs. 51.1% for B's five-year ROI.

The example illustrates two important considerations to keep in mind when using ROI for
decision support:

1. For most business investments there is not a single ROI for the investment,
independent of the time period. Because business investments typically bring
financial consequences extending several years or more, the investment can
have a different ROI every year (or other period). The investment's ROI is not
defined, that is, until the time period is stated.
2. The standard advice usually repeated when ROI is explained (as above) is: this:
"Other things being equal, the investment with the higher ROI is the better
business decision." However, important business decisions are rarely made on the
basis of one financial metric and with business investments, moreover, the
 condition "other things being equal" almost never applies. When comparing
investments with ROI, it is usually a very good idea to consider other financial
metrics as well (as illustrated in the following section).

As a final consideration in calculating ROI, note that some financial specialists prefer
to derive ROI from cash flow stream present values. In investment situations,
this typically leads to a lower ROI than the ROI from the non discounted cash flow. That
is because the larger investment costs usually come early, and the larger gains appear
later, so that discounting impacts the future gains more heavily than the future costs. In
the "early costs / later gains" situation, using discounted cash flow figures to calculate
ROI leads to a more conservative, less optimistic result. There are "pros" and "cons" to
both the discounted and non discounted approach to ROI, and the business analyst should
be sure to understand which approach is preferred by the organization's financial officers,
and why.

See the discounted cash flow entry in this encyclopedia, for a complete introduction to
present value and other time value of money concepts. For working spreadsheet examples
of the calculations in this and the following section, see Financial Metrics P
Disadvantages of the Return on Investment ROI ratio?

Easily manipulated

The calculation of Return on Investment can be easily modified based on the analysis
objective. It depends on what we include in revenues and costs.

Return on Investment (ROI) is a traditional financial measure similar to Return

on Equity (ROE) that is used to measure corporation's profitability that reveals how much
profit a company generates with the money and other sources from investors.

Return on Investment is based on historic data. It is a backward-looking metric that

yields no insights into how to improve business results in the future.

It is the ratio of money gained or lost on an investment relative to the amount of money
invested.
Return On Investment - Do You Know Your Numbers?
You’ve been following your stock trading plan to the letter. You’ve integrated
portfolio diversification, implemented a plan for stock technical analysis and
started using Japanese Candlesticks for your stock trading system. You have
even executed Strangle Buys and even Bear Call Spreads. But since the most
important thing is the bottom line, have you graded your results? What exactly is
your Return on Investment?

It is quite important to know and understand your Return on Investment. This

calculation reflects your performance in the stock market. First, every investor
needs to know how well he or she has performed against their stock investing
system. If the results are good, the trading plan is working. If the results are poor,
changes to the trading plan may be necessary. A diversified portfolio is great, but
if it isn’t generating a return, something needs to change. Second, calculating
Return on Investment is good, but do you know how to do it in a meaningful way?

There are several calculations that will give you an idea as to whether you are a
successful trader. Some are more complicated than others, but none are above
conquering with a standard calculator. Several of the calculations you can use to
help you understand your Return on Investment are:

Total Return
This stock analysis calculation is actually simple; it contains a reminder that it is
necessary to include dividends (where appropriate) when figuring the return of a
stock. The calculation is as follows: (Value of investment at the end of the year –
Value of investment at beginning of the year) + Dividends / Value of investment
at beginning of the year = Total Return. For example, if you bought a stock for
$10,000 and now it is worth $12,000, you have an unrealized gain of
$2,000. During this particular year, you also received dividends of $500. What is
the total return? ($12,000 - $10,000) + $500 / $2,500 = 25% Total Return. Since
it is not based on actually sales, you can use this calculation for any time period
but it will not reflect a growth rate for long term investing.

Simple Return
Simple Return is similar to Total Return; however it is used to calculate your
return on an investment only after you have sold it. The calculation is as follows:
Net Proceeds + Dividends / Cost Basis – 1. For example, you bought a stock for
$2,000 and paid a $12 commission. Your cost basis is $2,012. You sell the stock
for $3,000 and there is another $12 commission, so your net proceeds are
$2,988. Dividends amounted to $250. ($2,988 + $250 / $2,012) - 1 = 61%
Simple Return. Like the Total Return calculation, the Simple Return tells you
nothing about how long the investment was held only if it was a successful trade
or not.
Compound Annual Growth Rate
For investments held more than one year, it could be this calculation could be
more of an accurate reflection because it shows the time value of a Return on
Investment. This is important because 25% Return on Investment in one year is
impressive, but a 25% Return on Investment in ten years is not exactly stealing
from the stock market. For example, after making a $1,000 investment two years
ago, it is now worth $1,500. To calculate the CAGR for this example, you take
the nth root of the total return, where "n" is the number of years you held the
investment. In this example, you take the square root (because your investment
was for two years) of 50% (the total return for the period) and get a CAGR of
22.5%.

Understanding a Return on Investment is important for an investor who wants to

make money investing in stocks. By understanding the Return on Investment, a
trader can know what is working in his or her trading plan and what is not
working. The bottom line defines the investor and Return on Investment is that
bottom line.