What is a ROI?
ROI, or Return on Investment, is a measure of the profitability of an investment. It is used to evaluate the performance of investments and compare the returns of different investments. The ROI calculation is simple and straightforward, making it a popular and widely-used metric for measuring the performance of investments.
ROI is calculated by dividing the profit from an investment by the initial cost of the investment, then multiplying the result by 100 to express it as a percentage. The formula for ROI is:
ROI = (Profit / Initial Investment) * 100
For example, if you invested $1,000 in a stock and received a return of $1,200, your ROI would be 20%.
ROI is a useful metric for evaluating the performance of investments because it provides a simple and straightforward way to compare the returns of different investments. By calculating the ROI for each investment, you can compare the returns of stocks, bonds, real estate, and other investments to see which ones are performing the best.
ROI is also useful for evaluating the risk associated with different investments. Generally, investments with higher ROI are considered to be riskier than investments with lower ROI. This is because investments with higher ROI have the potential to generate higher returns, but they also have a higher risk of losing money.
Simplified Example
Think of ROI like planting a seed in a garden. When you plant a seed, you're making an investment by putting time and resources into the seed. The ROI for your investment would be how much the plant has grown, how many flowers or fruits it has produced, and how much you've earned from selling them.
For example, let's say you invested $10 in buying seeds and soil for your garden. After a few months, your plants have grown and you've sold the flowers and fruits for $15. Your ROI would be $5, because you made $5 more than what you invested.
History of the Term "Return on Investment (ROI)"
In the 17th century, economists like Locke and Smith explored the link between capital investments and economic benefits. By the 19th century, "return on capital" gained traction. In 1914, Donaldson Brown introduced a formula for calculating "return on investment," shaping the DuPont Method and laying the groundwork for modern ROI. Adopted widely in the mid-20th century, ROI expanded beyond finance. It now assesses project success, marketing effectiveness, and various decision outcomes.
Examples
Real Estate Investment: An individual invests $100,000 into a rental property that generates $12,000 in annual rental income. The property appreciates in value by $20,000 over the next year. The ROI for this investment can be calculated as: ($12,000 + $20,000) ÷ $100,000 = 0.32 or 32%. This means that the individual's initial investment of $100,000 has returned a profit of 32% over the course of a year.
Stock Investment: An individual invests $10,000 in a publicly traded company's stock. Over the next year, the stock's value increases by 50%, rising from $10,000 to $15,000. The ROI for this investment can be calculated as: ($15,000 - $10,000) ÷ $10,000 = 0.5 or 50%. This means that the individual's initial investment of $10,000 has returned a profit of 50% over the course of a year.
Small Business Investment: An individual invests $50,000 into a small business, providing the business with the capital it needs to expand and grow. Over the next year, the business generates $80,000 in profit. The ROI for this investment can be calculated as: ($80,000 - $50,000) ÷ $50,000 = 0.6 or 60%. This means that the individual's initial investment of $50,000 has returned a profit of 60% over the course of a year.