Return On Investment (ROI): How To Make The Formula Make Sense

Whenever you make an investment, the most important thing you are likely looking for is profitability. One way to compare investments and determine how well yours is performing is to figure out its “return on investment,” known as ROI. Let’s find out what ROI is, how to calculate it, and what you should consider to maximize yours.

What Is Return On Investment?

ROI is a common financial tool to predict the profitability of an investment by calculating the ratio of profit over cost (expressed as a percentage). Investors will use ROI as a rudimentary screening tool while understanding that the metric doesn’t factor in the variable of time.

ROI is used for many different types of investments, from choosing a stock to deciding to invest in a specific business or evaluating the benefits of a real estate transaction.

It’s useful as a metric because it allows you to take an objective look at an investment without being swayed by emotion. That can be a key consideration when you’re deciding to invest in a stock or a business that has been recommended by a trusted friend or family member or that you personally admire. Sometimes those emotions can color the financial practicality.

ROI is also helpful when making a real estate decision: Sometimes you fall in love with a home that might not have the fundamentals you need; on the other hand, you might be tempted to pass up a house for a superficial reason when it actually might have a great ROI that could help you reach your financial goals.

ROI is distinct from rate of return and return on equity because it uses the investment’s initial cost to determine how well it has performed.

To state it as a formula, ROI is calculated as the net profit divided by the cost of the investment times 100.

How To Calculate ROI

The ROI formula is a performance measure used to evaluate the efficiency or profitability of an investment or compare the efficiency of a number of different investments when deciding which to choose.

In ROI calculations, the benefit (or return) of an investment is divided by the cost of the investment. Here’s how it looks as a formula:

ROI = (Net Profit / Cost Of Investment) x 100

The net profit is often the most difficult component of the equation to determine. After all, you will know the cost of the investment, as in how much you initially paid. But then you need to factor in nuances such as the cost of a mortgage refinance if you used one, interest, maintenance costs, property taxes, utilities, etc. to figure out your net profit.

When considering a stock investment, the net profit should also include a total of the fees you have paid, which are required by many top investment apps and can cut into your overall profitability.

What Is A Good ROI?

Figuring out if you’re making a “good” ROI can be subjective, but of course you want to know whether your investment is helping your financial situation.

There are some rules of thumb that can help you determine if the ROI is “good.” One common ROI amount mentioned in the stock market is whether your investment is making 6% per year. That’s because the average return in the stock market is 10%, but many years are far from average. You’ll have good and bad years, but if you maintain a steady 6%, you are liable to be up overall. When considering which stocks to buy for the best ROI, consider industries that historically have strong sales, such as health care and technology, or stick with companies you understand or that are leaders in their market.

For real estate a good ROI is usually above 8%, heading toward 10% to 12%. Again, you’ll need to take into account the money you invest in addition to the purchase price, such as mortgage fees, costs for repairs or updating and ongoing maintenance while you get it ready to sell.

Of course, any discussion of investments and ROI has to take into account your risk tolerance, time horizon (how much time until you’ll need the money), and your goals. We recommend having these discussions with a financial professional.

When To Use ROI

ROI is just one metric to consider among others, and its importance can vary according to your goals for an investment. For example, if you are buying a house to rent out, you might not be trying to make a profit, but to ensure cash flow that covers your mortgage and other costs, knowing that down the line the property is bound to appreciate when you are ready to sell it.

When considering how to buy your first investment property, keep in mind that ROI might not be readily apparent if you are planning to buy and hold. In fact, that’s why you should note that ROI doesn’t reflect time, which is an important variable in any investment. The ROI today might not be as high as you like, but you might know that the investment has potential down the road, which will eventually boost its ROI. The fact that ROI doesn’t consider time also can make it difficult to compare investments since many will take longer than others to show a profit.

If your ROI is negative, you might be tempted to sell – and sometimes that is the right call if the company you’ve invested in is no longer a market leader or the area where your rental is located no longer commands high rates. But other times, patience can pay off when an investment increases over time and makes up that ROI. That’s when you want to also consider your risk tolerance and other factors when making financial decisions.

Alternatives To Using ROI

Of course, there are other ways to measure the benefits of an investment than ROI. One that is becoming popular takes into account more than just profitability; it also considers the broader impact of an investment. Known as social return on investment (SROI), it helps investors see whether the company is providing added value for the common good like sustainability and community outreach.

Another potential way to consider an investment is “annualized ROI,” which shows what an investor would earn over a period of time if the annual return was compounded. It can help you determine which investment options might be less volatile by seeing if the rates stay relatively even in each year rather than fluctuating up and down.

The Bottom Line: ROI Can Be A Quick Investment Screening Tool

When you’re looking at investments, the goal is always to maximize your profitability. ROI gives you a snapshot of how well an investment is performing in order to decide if it still fits within your financial goals. But remember that it’s just one way to consider whether an investment is right for you. If you are currently in the process of making an investment decision, you’ll want to make sure you’ve take into account factors such as investing risk tolerance and financial before making any decisions.