Return on Investment or ROI, as the name suggests, is a metric that is used to evaluate the measure of return one can get from any sort of investment. Not limited to investment in stocks, mutual funds, FDs and others but many think of ROI while taking any major life decisions as well. ROI makes it easy to measure the return on a particular investment with respect to the cost of investment.
ROI has become important in business decisions, capital purchases and investments or any other decision that requires a considerable chunk to be spent. ROI can be used by anyone from any walk of life. In this article, we have explained the in and out of the topic including return on investment meaning, formula with an example, benefits, limitation and FAQs.
What is Return on Investment?
In the context of financial investments, return on investment (ROI) means how much will your money grow if you invest in a particular stock or mutual fund or as the case may be. ROI can be calculated at different stages.
ROI can be used to get an idea of returns before investing anywhere, while one is in the middle of the tenure or after redemption, ROI can be used for equity and debt oriented instruments.
How to calculate Return on Investment?
Return on investment is calculated to check how much returns has your investment generated. It can be calculated in percentage terms.
ROI can be calculated using the following formula:
ROI Formula: [(Final value of investment-initial value of investment)/initial value] * 100
Let’s understand this with the help of an example.
Say A invested Rs 80,000 in an equity mutual fund that became Rs 96,000 at the end of two years, let’s calculate the ROI for this.
Here the return on investment is 20%.
Different investors can have different interpretations of how they want to calculate the returns from their investments. Some want to have a look at the annualised returns.
If we again consider the previous example, 20% is the returns that ‘A’ receives cumulatively over a period of two years. Annualized returns how much did the investor’s money grow each year to reach the final investment value.
In this context, annualised returns will tell us how much has Rs 80,000 grown every year to become Rs 96,000 at the end of two years.
Annualised returns; [(1+ROI)^1/n – 1]*100 . The answer is expressed in percentage terms.
ROI: Return on investment
n: number of years
Here the ROI is 20% and n= 2
[(1+20%)^1/2 – 1]*100 = 9.5% approximately.
Here the annualized return from the investment is around 9.5%.
Determining ROI using Calculators
While the aforementioned example was a very simple illustration of how one can calculate ROI using an ROI formula, investors can also use various calculators like lump sum calculator, SIP calculator to evaluate their returns on the respective investment.
Uses and Interpretation of ROI
- ROI is one of the metrics that can be used to understand the best return on investment.
- It can be used for any kind of investment. Be it traditional investments like fixed deposits or any other banking products, gold and other commodities, equities and bonds and any other market-linked products.
- ROI of any investment will be dependent on various factors that impact the performance of that asset class.
- Calculating ROI can be used to optimize one’s own financial investments portfolio.
- Projected ROI can be calculated on the basis of historical returns or any other historical data before getting into an investment
Benefits and Limitations
Versatile: Return on investment (ROI) is an all-pervasive metric which is used for different purposes and not just investments in financial instruments. ROI is a versatile metric.
Easy to use: ROI calculation is not rocket science and very easy to use and understand. This makes it an approachable metric for everyone. You don’t have to use complex tools or formulae to get an ROI on your investments.
Aids financial decision-making: ROI helps investors to get a better hold of their finances and get a faint idea of what to expect from the deployment of finances anywhere.
Does not account for inflation: One of the biggest limitations of ROI is that it does not take into account the factor of inflation. Considering the same example, Rs 80,000 may have risen to Rs 96,000 in absolute numerical terms. However, inflation, if it has risen considerably, reduces the value of money. So the 20% returns on investment may not necessarily mean that you can afford much more in absolute terms as well. Some of the best returns on investment account for all expenses and taxes.
Other expenses: ROI does not consider other expenses like investment cost, charges imposed by different investment platforms and any other extra charges that an investor has to incur.
Taxes: The returns that ROI calculation gives are not accounted for applicable taxes. So the figure you get at the end of the calculation may be lesser in real terms.
Evolution in ROI
Certain investors and businesses have delved deeper into the development of a new form of the ROI metric lately; it’s called “Social Return on Investment,” or SROI. Initially developed in the late 1990s, SROI considers broader impacts of projects by taking into account extra-financial values (i.e., social and environmental metrics not currently reflected in conventional financial accounts). SROI also helps to understand the value proposition of certain ESG (Environmental Social & Governance) criteria used in socially responsible investing (SRI) practices.
Return on Investment – Frequently Asked Questions
Ques. What is the return on investment ratio?
Ans. The return on investment ratio is a measure of profitability that determines the performance or potential return from a business or investment. The formula for ROI looks at the benefit received from an investment, divided by the initial investment cost.
Ques. What is considered a good ROI?
Ans. A good ROI depends on certain parameters such as the risk tolerance of the investor and the time period for the investment to generate a substantial return. Considering all other parameters being equal, risk-averse investors will likely have to accept lower ROIs as they are taking less risk. Similarly, investments with a longer tenure will generally generate a higher ROI in order to attract investors.
Ques. How is ROI calculated?
Ans. ROI can be calculated by subtracting the initial investment value from the final investment value (which equals the net return). The result is then divided by the cost of the investment and multiplied by 100.