The definition of 'Return on Investment (ROI)'
Return on Investment, often referred to as ROI, is a ratio used to calculate the profitability (gain or loss) of an investment as a percentage of the cost. Return on investment is expressed as a percentage and is often used to compare the profitability of different investments and investment types.
The ROI calculation is one of the most common investment ratios because it’s extremely versatile and very simple. It can be used by individual investors to calculate the return on an individual investment, by business angels to determine the return on their entire portfolio, or by management teams at companies looking to compare the potential returns from projects they must decide between.
The Return on investment formula
The formula for return on investment is incredibly simple. The net profit, or net loss, achieved is divided by the cost of the investment and then multiplied by 100. Return on investment (ROI) = (Net Profit / Cost of Investment) x 100 Net profit is calculated by subtracting the cost of the investment from the total returned. If you invested 100 into a stock and sold that stock for 120, your net profit would be 120-100 = 20.
Example using ROI
Over the years, Sarah, a recognised business angel, has invested £1,000 each into 10 different early stage companies. While most of her investments have not fared well, the expected outcome for early stage investors, a few of them have done ok and one in particular has done extremely well and increased in value by 10x. The breakdown of all of her investment returns is outlined below. Let’s use this to calculate the return on her investment for her portfolio. Returns from Sarah’s portfolio:
- 5 companies have failed and are now worth £0
- 2 companies have returned their initial investment of £1,000 each
- 1 company doubled in value and returned £2,000
- 1 company increased by 10x and returned £10,000
Step 1: Calculate the net profit
Adding up the total returned from Sarah’s portfolio we can see that she has received £14,000 back from her investments.
As Sarah initially invested £10,000 we calculate the net profit as £14,000 - £10,000 = £4,000
Step 2: Calculate the Return on investment
ROI = (£4,000/£10,000) x 100 ROI = 40%
Sarah’s return on investment for her portfolio is 40% which is a very healthy return.
Generally, any positive ROI is considered a good thing, particularly when it’s from riskier investments. A positive means that the investor has received back more than they initially invested.
One thing to remember though is that the calculation does not take into account the time value of money. For any investment there will be an associated cost, in the form of time and effort, for doing research, making comparisons, and ultimately deciding what to invest in. While the ROI calculation is very simple, it is not the most complete.
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