Return on investment

Return on investment (ROI) or return on costs (ROC) is a ratio between net income (over a period) and investment (costs resulting from an investment of some resources at a point in time). A high ROI means the investment’s gains compare favourably to its cost. As a performance measure, ROI is used to evaluate the efficiency of an investment or to compare the efficiencies of several different investments. In economic terms, it is one way of relating profits to capital invested.

Return on investment (ROI) is a performance measure used to evaluate the efficiency or profitability of an investment or compare the efficiency of a number of different investments. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost.

Return on investment, or ROI, is a mathematical formula that investors can use to evaluate their investments and judge how well a particular investment has performed compared to others. An ROI calculation is sometimes used along with other approaches to develop a business case for a given proposal. The overall ROI for an enterprise is sometimes used as a way to grade how well a company is managed.

If an enterprise has immediate objectives of getting market revenue share, building infrastructure, positioning itself for sale, or other objectives, a return on investment might be measured in terms of meeting one or more of these objectives rather than in immediate profit or cost saving.

To calculate ROI, the benefit (or 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 (ROI) formula is as follows:

 ROI= Current Value of Investment−Cost of Investment/ Cost of Investment

Purpose

In business, the purpose of the return on investment (ROI) metric is to measure, per period, rates of return on money invested in an economic entity in order to decide whether or not to undertake an investment. It is also used as an indicator to compare different investments within a portfolio. The investment with the largest ROI is usually prioritized, even though the spread of ROI over the time period of an investment should also be taken into account. Recently, the concept has also been applied to scientific funding agencies’ (e.g., National Science Foundation) investments in research of open source hardware and subsequent returns for direct digital replication.

ROI and related metrics provide a snapshot of profitability, adjusted for the size of the investment assets tied up in the enterprise. ROI is often compared to expected (or required) rates of return on money invested. ROI is not time-adjusted (unlike e.g. net present value): most books describe it with a “Year 0” investment and two to three years’ income.

Marketing decisions have an obvious potential connection to the numerator of ROI (profits), but these same decisions often influence assets’ usage and capital requirements (for example, receivables and inventories). Marketers should understand the position of their company and the returns expected. For a marketing ROI percentage to be credible, the effects of the marketing program must be isolated from other influences when reported to executives.  In a survey of nearly 200 senior marketing managers, 77 percent responded that they found the “return on investment” metric very useful.

Return on investment may be extended to terms other than financial gain. For example, social return on investment (SROI) is a principles-based method for measuring extra-financial value (i.e., environmental and social value not currently reflected in conventional financial accounts) relative to resources invested. It can be used by any entity to evaluate the impact on stakeholders, identify ways to improve performance and enhance the performance of investments.

Limitations with ROI usage

As a decision tool, it is simple to understand. The simplicity of the formula allows users to freely choose variables, e.g., length of the calculation time, whether overhead cost is included, or which factors are used to calculate income or cost components. The use of ROI as an indicator for prioritizing investment projects alone can be misleading since usually the ROI figure is not accompanied by an explanation of its make-up. ROI should be accompanied by the underlying data that forms the inputs, this is often in the format of a business case. For long-term investments, the need for a Net Present Value adjustment is great and without it the ROI is incorrect. Similar to discounted cash flow, a Discounted ROI should be used instead. One limitation associated with the traditional ROI calculation is that it does not fully “capture the short-term or long-term importance, value, or risks associated with natural and social capital” because it does not account for the environmental, social, and governance performance of an organization. Without a metric for measuring the short- and long-term environmental, social and governance performance of a firm, decision makers are planning for the future without considering the extent of the impacts associated with their decisions. One or more separate measures, aligned with relevant compliance functions, are frequently provided for this purpose.

Benefits of the ROI Formula

There are many benefits to using the return-on-investment ratio that every analyst should be aware of.

Universally Understood

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.

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”.