What is ROI? This simple financial metric assesses an investment's potential return in relation to its cost

• Return on investment (ROI) is a popular metric used to assess an investment's efficiency or profitability.
• ROI is calculated by dividing the net return earned on an investment by its total cost.
• ROI doesn't factor in the time value of money and can be less useful when evaluating long-term investments.

They say hindsight is 20/20, but when it comes to investing, calculating return on investment (ROI) can help you see clearly in the present - as a way to evaluate your investments and forecast potential profits.

ROI is a financial metric used to assess an investment's profitability or financial benefit. It's also helpful in comparing the profitability of multiple investments side-by-side. Expressed as a percentage, ROI measures an investment's overall return in relation to the investment's original cost. The higher the percentage, the greater the profitability.

While ROI can be useful to investors analyzing their investments, it does have a few limitations. Here's what you need to know.

Understanding ROI

Whether you invest in the stock market, real estate, or your own small business, return on investment is an important financial ratio for you to keep an eye on.

Investors and analysts like to apply the ROI metric because it's a relatively simple, quick method to assess the profitability of almost any transaction. It can be calculated on a stock holding or real estate investment, or used to project whether a potential venture, like building a new warehouse, will generate enough return to be worthwhile.

Put it this way: If the purpose of investing is to make money, the purpose of the ROI metric is to help you understand what kind of return you might get before you invest, so you can strategize accordingly.

How is ROI calculated?

To calculate ROI, divide the gain, or net benefit, earned from the investment by the cost of the investment, and then multiply by 100 to get a percentage.

The formula is as follows:

Your ROI can either be realized or unrealized, depending on whether or not you've sold the investment or are still holding it.

• A realized gain is the profit from an investment you've already sold. If that's the case, you'll use net income as the first number in the formula. Net income can be found by subtracting total investment costs, including fees and unpaid interest, from the total return.
• An unrealized gain is an increase in value of an investment you haven't sold yet. If this is the case, you'll use your current investment gain based on what the investment is currently worth.

Example of ROI in action

Let's say you bought a property for $250,000 (all in, including agent commissions and closing costs) and, three years later, sold it for $300,000. Here's what the ROI formula would look like for that example:

• ROI = ($300,000 - $250,000) / $250,000
• ROI = $50,000 / $250,000
• ROI = 20%

When interpreting an asset's ROI, there are a few things to consider. For one, positive ROIs mean that net returns exceed net costs, and the opposite is true for negative ROIs. Additionally, it's natural for ROIs in specific industries to shift either direction over time due to advancements in technology, heightened competition, and changes in consumer confidence or demand.

It should be noted that there's a key distinction between ROI and profit, which is calculated simply by subtracting cost from revenue. In comparison to profit, ROI measures an investment's effectiveness as a percentage, rather than just the money made in dollars.

Important: ROI is a subjective measurement, so a "good" ROI means something different for everyone. When determining an optimal ROI, consider risk tolerance and time horizon.

Cautious investors generally seeking quicker returns may accept a lower ROI in exchange for taking on less risk. On the flipside, those seeking potentially higher returns may be better suited for the higher risk that accompanies longer-term investments.

Limitations of ROI

Though ROI is a relatively easy to calculate, it's not without its limitations:

• It doesn't account for time. ROI does not consider an investment's holding period or the broader time value of money, which means it can be less accurate when assessing longer-term investments that take more time to turn a profit.
• It doesn't adjust for risk. There tends to be a direct correlation between risk and return, and generally speaking, the higher an investment's potential return, the greater the corresponding risk. It's important to remember that ROI projections do not evaluate associated investment risks.
• It can oversimplify the comparative process. When used to compare different companies, it's necessary that each firm follows similar accounting practices in order to maintain consistency. If companies value assets or define profit differently, it may render direct ROI comparisons inaccurate.

Quick tip: Not a math fan? That's OK. There are lots of online tools and calculators that can help. With most online annualized return calculators (Bankrate has a good one), you just plug in your investment data it takes care of all the heavy lifting for you.

Annualized ROI

As previously mentioned, simple ROI calculations do not take an investment's holding period into account, which means this metric cannot be used to calculate investments with compounded growth over time.

The annualized ROI formula does account for the investment's holding period, but is a bit more complicated to calculate. Here's what the formula looks like:

Example of annualized ROI in action

Using our real estate example above, here's how you would plug in the numbers to the annualized ROI formula. The key thing to remember is that in our example, the property had been held for three years, so that's the number that we'll put in where "years" is written above.

• Annualized ROI = ($300,000 / $250,000) (⅓) -1
• Annualized ROI = (1.2) 1/3 -1
• Annualized ROI = 1.063 -1
• Annualized ROI = .063
• Annualized ROI = 6.3%

So now we see that our total 20% rate of return translates to an annualized return of around 6%. That's a nice return, but not nearly as impressive.

Whenever you've held an investment for multiple years, you'll want to use the annualized ROI formula. It gives you a truer sense of how well the investment has really performed.

The financial takeaway

Return on investment is a simple and straightforward way to evaluate an investment's performance. It's a subjective measure that depends on factors like risk tolerance and time horizon, and is calculated by dividing the profit earned on an investment by its total cost.

Annualized ROI is a different formula that, unlike simple ROI, takes into account the length of the investment, and is helpful in computing compounded growth over time.

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