Return on investment (ROI) is the ratio of profit made in a financial year as a percentage of an investment. In other words, ROI reveals the overall benefit (return) of an investment using the gain or loss from the investment along with the cost of the investment.
Return on investment is a useful and simple measure of how effective a company generates profits from an investment. Many firms use ROI as a convenient tool to compare the benefit of an investment with the cost of the investment. For example, if a company effectively utilizes an investment and produces gains, ROI will both be high. Whereas if a company ineffectively utilizes an investment and produces losses, ROI will be low. For investors, choosing a company with a good return on investment is important because a high ROI means that the firm is successful at using the investment to generate high returns. Investors will typically avoid an investment with a negative ROI, or if there are other investment opportunities with a positive ROI. Return on investment models are used often because the ROI ratio and inputs can be modified to fit different companies and financial situations.
Simple Return on Investment Ratio = (Earnings from Investment – Cost of Investment) ÷ Cost of Investment
One issue with the simple return on investment formula is that it is often used for short-term investments, so it does not account for the time value of money. Thus, it is less accurate for calculating ROI for long-term investments over one year. To measure the long term return on investment for future years, use the discounted ROI formula.
Discounted Return on Investment Ratio = Net present value of benefits ÷ Total present value of costs
= (PV Earnings from Investment – PV Cost of Investment ) ÷ PV Cost of Investment
For example, this year, ABC company has produced earnings of $50,000 from an investment. The cost of the investment was $30,000.
Simple Return on Investment Ratio = ($50,000 – $30,000) ÷ $30,000 = 67%
Based on the result, we assume that ABC company has an annual percentage return on investment of 67%. The benefit (gain) was $50,000 and the investment cost was $30,000.
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