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.
The most commonly used ROI formula is net profits divided by the total cost of the investment.
For example, take a person who invested $90 into a business venture and spent an additional $10 researching the venture. The investor's total cost would be $100. If that venture generated $300 in revenue but had $100 in personnel and regulatory costs, then the net profits would be $200.
Using the formula, ROI would be $200 divided by $100, for a quotient, or answer, of 2.
Because ROI is most often expressed as a percentage, the quotient should be converted to a percentage by multiplying it by 100. So this particular investment's ROI is 2 multiplied by 100, or 200%.
Compare that to another fictitious example: An investor put $10,000 into a venture without incurring any fees or associated costs. The company's net profits were $15,000. The investor made $5,000. It's significantly more than the $200 in net profits generated in the first example. However, the ROI offers a different view: $15,000 divided by $10,000 equals 1.5. Multiplied by 100 yields an ROI of 150%.
Although the first investment produced fewer dollars, the higher ROI indicates a more productive investment.
What is ROI used for?
ROI measures can be used to evaluate various types of investments. Businesses also use ROI calculations when evaluating potential investments or the success of prior investments.
Individuals can calculate ROIs to judge their own personal investments and compare one investment -- whether it's a stock holding or a financial stake in a small company -- against another in their own investment portfolios.
However, calculating the figures for each piece of the equation can be complicated for businesses who frequently have to determine various elements of each part of the equation.
Example of ROI calculations: Investing in new computers
Calculating the investment figures for each piece of the ROI equation can be complicated for businesses.
For example, if a company wants to invest in deploying new computers, they must consider a variety of deployment costs. The business would have to consider the actual price of the computers, plus tax and shipping costs, plus consulting fees or support costs paid to purchase, plus setup costs and maintenance costs.
Then, the business would have to calculate net profits over a set period of time. These net profits could include hard dollar amounts coming from increased productivity and a reduction in maintenance costs compared to the previous computer system.
That business could calculate that ROI when evaluating two different types of computers using anticipated costs and projected gains to determine which ROI is higher. Therefore which computer represents the better investment: Investment A or Investment B?
The business could also calculate the ROI at the end of the set time period using actual figures to then compare the actual ROI to the projected ROI to evaluate whether the computer implementation met expectations.
ROI is one of the most common investment and profitability ratios used today. However, it does have some limitations.
One potential drawback to this formula is its inability to consider time in the equation. Take the first two examples cited above: The 200% ROI is higher than the 150% ROI. On the surface, the higher ROI seems like the more productive investment. But, what if the investment took 10 years to produce that 200% ROI, while the second investment took just one year to produce the 150% ROI?
Investors can sometimes account for time by paying extra attention to the figures they're using as inputs into the formula. In the case of the new computer example above, investors could use the net profits produced in the first year for Investment A and compare them with the net profits produced for Investment B in the first year, thus ensuring a more apples-to-apples comparison, if the time holding the investment is important to the investor. Other metrics, such as rate of return, have such time elements actually incorporated into the formula.
Another drawback of using the ROI formula is that it does not have a way to account for non-financial benefits. Take the ROI for the new computers example: The business can use specific dollar amounts to calculate the net profit and total costs to come up with an ROI. However, calculating the value of improved worker morale as a result of getting new computers is difficult to do. Businesses often calculate ROIs for such nontangible benefits, frequently labeling these calculations as soft ROIs while the calculations made with actual, tangible dollar amounts are called hard ROIs.