How do you know if an investment is actually profitable? If you are seeking to make your money grow for a healthy financial future, being able to answer this question is key to having agency over your investments and understanding the value of your investments. One important acronym to help us answer this question is ROI, or return on investment.
What is a ROI? How do you calculate it? In this article, we’ll answer these questions so you can begin learning how to make healthy investment decisions.
What is a return on investment?
ROI is a measure typically expressed as a percentage that helps investors evaluate and compare the profitability of their investments. In essence, it allows you to calculate how effective your investments are.
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When you compare the ROIs of different investments, you can get an idea of which investment is a “better bang for your buck,” so to speak. It is fairly easy to calculate once you understand the concept.
How do you calculate ROI?
ROI is a measure of profitability. In order to calculate profitability, it is essential to take into account the costs associated with the initial investment, since those costs detract from the ultimate profit.
As such, ROI is calculated as net profit divided by the initial investment. Net profit is calculated by subtracting investment-related (or business-related expenses) expenses from the overall profit. To express it as a percentage, make sure to multiply the dividend of net profit / initial investment by 100.
As a formula, the ROI percentage is:
ROI = (Net profit / Initial investment) x 100
If formulas aren’t quite your thing, consider this example. Imagine you invest in two promising stocks: Petey’s Pizzas Inc. and Carla’s Cakes Corp. If you invest $2,000 in Petey’s Pizzas and then sell your stock in the company for $2,400 one year after your purchase date, you will have made a profitable investment. If you also invest $4,000 in Carla’s Cakes and then sell your stock for $5,800 one year later, you will also have made a profitable investment.
But which investment was “better”?
One way we can determine which stock was more profitable is by calculating and comparing each investment’s return.
Petey’s Pizzas Inc.
([$2,400 profit – $2,000 investment] / $2,000 investment) x 100 = an ROI of 20%
Carla’s Cake Corp.
([$5,800 profit – $4,000 investment] / $4,000 investment) x 100 = an ROI of 45%
So, who takes the cake on profitability? According to our ROI comparison, Carla’s Cakes Corp. had a 25% higher return on investment.
Issues with ROI
While our example shows that ROI can be a delightfully simple tool to compare investments, there are a few important additional factors to take into consideration when calculating the profitability of an investment or business.
One of the most important factors that this formula doesn’t take into account is time value of money. What if, in our imaginary investment example, you had a 20% ROI on Petey’s Pizza over the course of one year, but a 45% ROI on Carla’s Cakes over the course of one decade?
While it might be said that, over the long term, Carla’s Cakes is more profitable, in this case, Petey’s Pizza would have a better annual ROI: 20% versus just 4.5% for Carla’s Cakes (the overall ROI is divided by number of years).
Tweaking the ROI formula can help us to more accurately compare the profitability of different companies and investments, other figures like rate of return can also be helpful tools.
The bottom line
Investing is a key part of keeping your financial health in shape. As you begin studying investing strategies, understanding key terms like ROI can help you make good decisions for your future.
For more information on other personal finance and investment tips, check out the rest of the Academy library.
