Measuring returns; ROI, Absolute returns, Annualized return13/10/2022 0 By indiafreenotes
Return on investment (ROI) is a financial ratio used to calculate the benefit an investor will receive in relation to their investment cost. It is most commonly measured as net income divided by the original capital cost of the investment. The higher the ratio, the greater the benefit earned.
There are several versions of the ROI formula. The two most commonly used are shown below:
ROI = Net Income / Cost of Investment
ROI = Investment Gain / Investment Base
Benefits of the ROI Formula
There are many benefits to using the return on investment ratio that every analyst should be aware of.
Simple and Easy to Calculate
The return on investment metric is frequently used because it’s so easy to calculate. Only two figures are required the benefit and the cost. Because a “return” can mean different things to different people, the ROI formula is easy to use, as there is not a strict definition of “return”.
Return on investment is a universally understood concept so it’s almost guaranteed that if you use the metric in conversation, then people will know what you’re talking about.
Limitations of the ROI Formula
While the ratio is often very useful, there are also some limitations to the ROI formula that are important to know. Below are two key points that are worthy of note.
The ROI Formula Disregards the Factor of Time
A higher ROI number does not always mean a better investment option. For example, two investments have the same ROI of 50%. However, the first investment is completed in three years, while the second investment needs five years to produce the same yield. The same ROI for both investments blurred the bigger picture, but when the factor of time was added, the investor easily sees the better option.
The investor needs to compare two instruments under the same time period and same circumstances.
The ROI Formula is Susceptible to Manipulation
An ROI calculation will differ between two people depending on what ROI formula is used in the calculation. A marketing manager can use the property calculation explained in the example section without accounting for additional costs such as maintenance costs, property taxes, sales fees, stamp duties, and legal costs.
The absolute return or simply return is a measure of the gain or loss on an investment portfolio expressed as a percentage of invested capital. The adjective “absolute” is used to stress the distinction with the relative return measures often used by long-only stock funds that are not allowed to take part in short selling.
The hedge fund business is defined by absolute returns. Unlike traditional asset managers, who try to track and outperform a benchmark (a reference index such as the Dow Jones and S&P 500), hedge fund managers employ different strategies in order to produce a positive return regardless of the direction and the fluctuations of capital markets. This is one reason why hedge funds are referred to as alternative investment vehicles.
Absolute return managers tend to be characterised by their use of short selling, leverage and high turnover in their portfolios.
The formula for absolute return is:
Absolute returns = 100* (Selling Price – Cost Price)/ (Cost Price)
It offers multiple advantages. A few of the noteworthy are enumerated below:
- First, it is straightforward to calculate and understand for all users.
- Second, it is unaffected by period and benchmark comparison and provides returns generated in actual terms.
- Third, it helps in reducing overall volatility as it doesn’t consider intermittent changes.
- It isn’t easy to compare across other asset classes.
- It is a fault measure when comparing different time frames.
- It doesn’t compare against any benchmark, which results in determining the relative performance. Also, absolute return lacks adjusting returns for inflation, leading to negative returns despite absolute returns showing a positive value.
- These measures don’t allow investors to assess the efficacy of the Fund manager and whether they can generate positive alpha. Also, this measure completely avoids assessing risk-adjusted returns.
- It is not comparable, which makes it an adequate measure of performance.
- It can lead to the selection of those investments where risk is higher as it doesn’t consider risk measures such as Standard Deviation and other performance ratios such as Sharpe Ratio, Treynor Ratio, etc.
The annual return is the return on an investment generated over a year and calculated as a percentage of the initial amount of investment. If the return is positive (negative), it is considered a gain (loss) on the initial investment. The rate of return will vary depending on the level of risk involved.
Annual Return Formula
The return earned over any 12-month period for an investment is given by the following formula:
Annual Return = [(Final value of Investment – Initial value of Investment) / Initial value of Investment] * 100
- It is very easy to calculate and simple to understand like payback period. It considers the total profits or savings over the entire period of economic life of the project.
- This method recognizes the concept of net earnings i.e. earnings after tax and depreciation. This is a vital factor in the appraisal of a investment proposal.
- This method facilitates the comparison of new product project with that of cost reducing project or other projects of competitive nature.
- This method gives a clear picture of the profitability of a project.
- This method alone considers the accounting concept of profit for calculating rate of return. Moreover, the accounting profit can be readily calculated from the accounting records.
- This method satisfies the interest of the owners since they are much interested in return on investment.
- This method is useful to measure current performance of the firm.
- The results are different if one calculates ROI and others calculate ARR. It creates problem in making decisions.
- This method ignores time factor. The primary weakness of the average return method of selecting alternative uses of funds is that the time value of funds is ignored.
- A fair rate of return cannot be determined on the basis of ARR. It is the discretion of the management.
- This method does not consider the external factors which are also affecting the profitability of the project.
- It does not take into the consideration of cash inflows which are more important than the accounting profits.
- It ignores the period in which the profits are earned as a 20% rate of return in 10 years may be considered to be better than 18% rate of return for 6 years. This is not proper because longer the term of the project, greater is the risk involved.
- This method cannot be applied in a situation when investment in a project to be made in parts.
- This method does not consider the life period of the various investments. But average earnings are calculated by taking life period of the investment. As a result, average investment or initial investment may remain the same whether investment has a life period of 4 years or 6 years.
- It is not useful to evaluate the projects where investment is made in two or more instalments at different times.