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What is the Return on Investment (ROI)?

by | Last updated 26 Nov, 2022 | How to start investing, Investing Basics

Return on Investment (ROI) is a basic financial metric used to calculate how much profit an investor has made over the original cost of an investment. The ratio is expressed as a percentage and indicates how efficiently an investment has performed in building wealth.

Return on Investment helps understand at what rate an investment will yield a profit or a loss. And its percentage format makes it easy to compare options making it suitable for rapid cost-benefit analysis.

That’s why it’s often used by individuals as well as businesses when making investment decisions for almost any asset class, including stocks, bonds, and real estate.

How to Calculate ROI and why is it important?

The basic return on investment formula is:

ROI = \frac{(Current Value of Investment - Cost of Investment)}{Costof Investment}

Let’s say I have £1,000 available for investing in the stock market, and I decide to buy shares in ABC Group. One year later, my investment is now worth £1,250. What is my Return on Investment?

ROI = \frac{1250 - 1000}{1000} = 0.25 \equiv 25%

In this hypothetical example, my investment yielded a 25% return on investment. However, in practice, things are a bit more complicated as there are additional costs to consider in the ROI formula, such as trading fees and taxes.

Let’s say I had to pay £10 commission to my broker on my buy and sell transactions (£20 total), and I have to pay a 10% capital gains tax. What is my Return on Investment now?

Of the £1,000 invested, £10 is gobbled up by the trading commission, which means only £990 is used to buy ABC Group shares. This means after the shares have gone up 25%, the same as before, my current investment value is now £1,237.50.

When I’m selling the shares, I have to pay an additional £10 in trading commission, bringing the position value down further to £1,227.5. It also happens to be the end of the tax year, and I need to pay a 10% capital gains tax on the profits of my investment. 10% of £237.5 is £23.75, which must be subtracted from my total position value.

Therefore the final total position value in this example when calculating ROI is £1,203.75.

ROI = \frac{1203.75 - 1000}{1000} = 0.2038 \equiv 20.38%

Investors can often forget trading commissions and taxes. But the previous example highlights the impact these factors can have on investment returns. Selecting a low-cost brokerage account can help reduce this impact. Similarly, tax-efficient accounts, like the Stocks and Shares ISA, can remove the tax bill from the equation.

ROI is important for all types of investments and helps individuals, as well as businesses, make better decisions when deciding where to allocate capital in the pursuit of the highest net return.

What is a good Return on Investment?

As ROI demonstrates how much profit has been generated on an investment, the higher the value, the better. But what threshold is considered a good ROI? And what level of returns should a stock investor be expecting?

On paper, any project or investment with a positive ROI is good. However, in practice, as people and companies don’t have unlimited resources to pursue every project, only the highest ROI opportunities should be considered.

In terms of investing in the stock market, the ROI is typically only considered good if it meets or exceeds a benchmark index’s average performance.

The table below compares the leading UK and US indices’ total average annualised ROI (capital gain + dividend) over the last decade.

ABC GroupFTSE 100FTSE 250S&P 500
Return on Investment20.38%8%11%10%

Based on these benchmark index returns, the ROI on my hypothetical investment in ABC Group was excellent even after the additional trading and tax expenses.

How to increase Return on Investment?

There are two ways to improve the return on investment:

  • Increase the return – Find and capitalise on better investment opportunities that unlock greater wealth-building potential. For investors, the probability of executing a more lucrative long-term investment increases when investing in high-quality companies or real estate. For businesses, finding methods of increasing sales while keeping costs fixed opens the doors to more significant earnings.
  • Reduce the cost – Using low-cost investing platforms and tax-efficient accounts can eliminate additional expenses that eat into profits. Buying an asset at a lower price also opens the door to a superior return on investment. For example, buying shares when they are trading below the intrinsic value of the underlying business.

What are the limitations of ROI?

Despite being a simple and popular financial metric to judge the quality of an investment, the Return on Investment has several limitations.

  • ROI does not take into consideration the time value of money. Inflation adversely impacts the spending power of the generated returns.
  • ROI does not consider time. A 20.38% return on investment is excellent if achieved within one year. But a seemingly strong investment opportunity could be worthless if it takes over a decade to deliver this return.
  • ROI does not consider risk. A project with a 30% ROI may look better than another one with only a 15% ROI. However, the first project could have a high chance of failure that this financial metric does not capture.
  • ROI may not take additional income received into account during the investment period. Passive income such as stock dividends, debt interest payments, and rent all contribute to the final return on investment. However, it can be difficult to accurately predict when an investment timeline is longer than a year.
  • Using ROI to judge the quality of an investment may overlook strong qualitative aspects of a business that could grant the upper edge over competitors in the long run.

Alternatives to Return on Investment

ROI can be a terrific way to assess investment opportunities quickly. But given the limitations, it isn’t perfect. Therefore, additional factors need to be considered to make an informed decision.

Let’s quickly explore some popular alternatives.

Return on InvestmentInternal Rate of ReturnReturn on Equity
What does it calculate?Measures the profitability of a business/investment in relation to the original cost.Measures an investment’s net gain or loss over a specified period.Measures the profitability of a business in relation to its equity.
PurposeIt’s completely profit-based and only talks about an investment’s profitability.Calculates return on the initial investment.It reveals how much value a company is creating using shareholder capital.
Debt included?It includes any amount of debt taken for an investment.It includes any amount of debt taken for an investment.Debt is not accounted for while calculating ROE.

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Views expressed on the companies and assets mentioned in this article are those of the writer and, therefore, may differ from the opinions of analysts in The Money Cog Premium services.

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