ROI: Understanding And Calculating Return On Investment

Investments are crucial decisions and should be done with proper consideration. Investors make an investment to potentially retain and grow the value of money against the phenomenon of the time value of money. There are various ways to evaluate return on an investment. Let us decode everything about return on investment calculation and evaluate its advantages and disadvantages.

What Is Return On Investment?

Return on Investment or ROI is a tool to calculate the profitability of an investment compared to the initial expense (investment) of an investor. It can be applied to various investment decisions. Moreover, different investments can be compared based on return on investment. ROI of an investment is a key financial metric to evaluate relative profitability, expressed in %. 

How To Calculate ROI?

The return on investment formula includes investment and profit/loss from investment. It can be calculated in two ways. 

Interpreting ROI

Both the methods used to calculate ROI are interpreted as growth of investment. However, investors should consider that this growth in % and the net investment returns can be positive or negative. When the ROI is positive, the returns exceed investment cost, while in negative ROI, the cost exceeds the return.

ROI Example

Calculating ROI may be perceived as easy, but it requires accurate figures regarding cost and return on investment. This example can help individuals understand the ROI formula.

For example, Ms ABC purchased 50 equity shares of INR 300 each, which totalled her investment to INR 15000. She received a dividend of INR 10 per share over her holding period of 5 years. She sold this investment of 50 shares at INR 450 per share. However, she had to pay INR 1000 as brokerage fees. 

Step 1: Investment cost = 15000+1000 = 16000

Step 2: Investment return = (50*10) + (50*450) = 23000

Step 3: Net investment return = 23000 - 16000 = 7000

Step 4: Hence, Return on Investment (ROI) = (7000/16000)*100

      ROI = 43.75%

Note: Here, we do not include the cost of brokerage commission in the denominator as it is not the part of initial investment cost. 

Annualised ROI

While using the above-mentioned return on investments formula, we miss the impact of time. However, annualised ROI can easily accommodate this effect. It can provide a more realistic picture to compare with other security of previous returns from an investment. 

For example, we can understand the effect of annualised returns with the help of the above-given example, which earned an ROI of 43.75% over a 5-year holding period.

When we calculate simple annual average returns, we divide the total returns by a the number of years:

Simple annual average returns = 43.75/5 = 8.75%

However, we miss the effect of compounding in this calculation. It can be one of the key objectives of investment management. Therefore, we can calculate the compounded annual ROI:

Annualised ROI = [(1+(83.75/100))^? - 1]*100 =  12.93%

Therefore, an investment is compounded at the rate of 12.93% to gain the final return on investment of 43.75%

Comparing Investments And Annualised ROI

Annualised returns are one of the most suitable ways to compare the investment options. One can ascertain the compounding rate to gauge the investment growth in the upcoming years or during the holding period.

Understand the comparison with this example:

• Mr PQR invested INR 50,000 in shares of LKG company. He held the investment for six years and sold it fully at INR 80,000.

ROI = [(80,000-50,000) / 50,000] * 100 = 60%

Annualised returns = [(1+(60/100))^^1/6 - 1]*100 = 8.14%

• Mr PQR also invested INR 50,000 in the fixed deposit, offering 12% simple interest. It matured after six years.

ROI = [(50,000*12%*6)/50,000]*100 = 72%

Annualised ROI = [(1+(72/100))^^1/6 -1] *100 = 9.45%

The fixed deposit offered better returns than shares, in this case. However, this can differ based on investment instrument, rate of return, holding period, other incomes and expenses.

Evaluating The Pros and Cons

The rate of return on investment is one of many potential ways to evaluate an investment option. However, like every coin has two sides, this tool is also accompanied by some advantages and disadvantages.

Advantages Of ROI

It is one of the easiest methods that can also be understood by laymen. This simplicity also makes it the most favourable. Almost all the interfaces or instruments show basic ROI that simplifies the comparison task. It focuses on the profitability of an investment. Moreover, it can be used in performance tracking and strategic analysis.

Disadvantages Of ROI

One of the main limitations of this investment calculator measure is that it does not account for time, which is a crucial element of any investment. The time value of money can erode the present value of money in future. Moreover, the authenticity of data for calculating the ROI is crucial. 

The ROI formula also does not account for the element of risk that may differ based on investment instrument, time and other aiding conditions. To accommodate risk, investors need to seek separate risk-adjusted return calculation methods.

An Alternative ROI Calculation

The rate of return can be calculated in various ways, as mentioned previously in this article. However, to avoid any human error and get an accurate result, investors can use the rate of return calculator available online from an authentic source. Moreover, one can also use tools such as Microsoft Excel and Google Spreadsheets as annual rate of return calculators.

Conclusion

An investment decision should be accompanied by required analysis and research to potentially avoid any mishap. One of the simplest ways for this calculation can be return on investments or ROI. It is widely used and makes comparison of investment quite simple. However, it misses the effect of time value of money and risk, which can be accommodated by annualised ROI.

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