Return on Investment (ROI)

What It Is:

Return on investment (ROI) measures the gain or loss generated on an investment relative to the amount of money invested. ROI is usually expressed a percentage and is typically used for personal financial decisions, to compare a company's profitability, or to compare the efficiency of different investments.

The return on investment formula is:

ROI = (Net Profit - Cost of Investment) * 100.

How It Works/Example:

The ROI calculation is flexible and can be manipulated for different uses. A company may use the calculation to compare the ROI on different potential investments, while an investor could use it to calculate a return on a stock.

For example, an investor buys $1,000 worth of stocks and sells the shares two years later for $1,200. The gain from the investment would be $200 and the ROI would be calculated as follows:

ROI = ($200 - 1000) * 100 = 20%

The ROI in the example above would be 20%. The calculation can be altered by deducting taxes and fees to get a more accurate picture of the total ROI.
The same calculation can be used to calculate an investment made by a company. However, the calculation is more complex because there are more inputs. For example, to figure out the net profit of an investment, a company would need to track exactly how much cash went into the project and the time spent by employees working on it. 

Why It Matters:

ROI is one of the most used profitability ratios because of its flexibility. That being said, one of the downsides of the ROI calculation is that it can be manipulated, so results may vary between users. When using ROI to compare investments, it's important to use the same inputs to get an accurate comparison.
Also, it's important to note that the basic ROI calculation does not take time into consideration. Obviously, it's more desirable to get a +15% reuturn over one year than it is over two years.