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What Is Return on Investment?

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Return on investment (ROI) is a measure that is often used to assess the performance of an investment. An investment's ROI can give you a general idea of how much value it has gained relative to its costs. Additionally, it can compare the profits earned by various investments relative to the capital invested in them.

Key Takeaways

  • ROI is a ratio that measures the profitability of an investment.
  • ROI is often used to compare the profitability of different investments, with a higher number indicating a more significant gain.
  • There are several ways of calculating ROI, but the most common method is a percentage calculated based on the investment's net value divided by the initial investment.
  • ROI does not account for the time an investment is held, so it fails to take the time value of money into account when comparing long-term vs. short-term investments.

Understanding Return on Investment

ROI is a popular metric for assessing an investment's ability to generate income or its rate of return. Investors like to use ROI because the calculation is relatively simple, and the information needed to calculate is often available. ROI is a ratio often expressed as a percentage and is commonly used to compare different investment alternatives and whether a current investment is an efficient use of resources.

Return on Investment Calculations

There are several ways that ROI can be calculated, but the most widely used equation is:

(Current Value – Cost of Investment)/Cost of Investment

In other words, it is the increase in the investment's value divided by its initial cost. That ratio is then expressed as a percentage. For example, if an investment in a stock currently valued at $10 was initially purchased for $5, the ROI would be 0.5 or 50%. That ROI calculation would look like this:

(10-5)/5=0.5

Limitations of Using ROI

Most critics of using ROI as a performance measure note that it fails to consider the time value of money (TVM). In essence, TVM is the concept that money you hold today is worth more than that same amount at a future date because you could have been earning additional funds by investing it in the interim.

An example of how ROI fails to take TVM into account would be if you compared a one-year investment with a five-year investment that both had a 25% ROI. While you would earn the same profit from either investment, the one-year investment allows you to take that 25% ROI and roll it over into additional investments during the time that your funds were tied up for the five-year investment.

Additionally, ROI fails to take an investment's degree of risk into account. A safe investment with a low ROI is usually preferable to a risky investment with a higher ROI. However, depending on your risk tolerance, if the potential ROI on investment is high enough, it may be worth the risk.

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