If you are a professional investor, you might have encountered a phrase- ROI. These three alphabets stand for “Return on Investment”. But, due to a lack of knowledge many people describe it as a “Return of Investment”. That not the end of the story. One more sad truth is that many investors miscalculate the return they get from the investment they did.
That's why I thought it would be a great idea to define what ROI means and how to calculate it. Whether you are a professional or beginner investor, you must learn how to calculate Returns on investment. To help you understand, I am going to answer some of the commonly asked questions related to ROI.
So, as we always do, let's start with the basics.
What does return on investment mean?
You will be glad to know that the ROI definition is not that difficult as you think. On the contrary, it is so simple that you can learn it in just a few couples of minutes. Let's come to the point.
As the name suggests, ROI is a financial term that is used to calculate whether you are on the losing end or gaining. You can think of it as a Financial ratio. This financial ratio is made of two major factors: One is net income and the second is the capital cost of the investment. It comes as a great help when it comes to calculating returns by dividing net income and capital cost of the investment you have done.
The simple way to understand how it works is to determine whether the value of the ratio is high and lower. In layman terms, just keep in mind this mantra. The higher the ROI ratio is, the greater would be the benefit. Let's have a close look at its formula for more clarification.
It is worth noting that there are multiple ways to calculate ROI. But, one of the most common ways of calculation is to divide net income by the cost of investment. Alternatively, what you can do is to divide investment gain by investment base.
The first formula is comparatively more popular than the second one. There is one more good thing to know about ROI. Whenever someone calculates ROI and shares the results with you, don't forget to ask for the way of calculation as it makes a difference.
Still, have doubts in your mind? Okay, not an issue. Let me try one more time.
In simple words, ROI is the result of what you have got back by dividing the benefits with cost (your expenses you paid). For more information, let's take an example:
Just suppose you purchased a house at $500,000. After three years, you sold the house for $1,000,000. So, the question is what would be the ROI ration? Here is the answer:
We know that ROI=(1,000,000 – 500,000) / (500,000) = 1 or 100%
There are three types of ROI that are generally used in the business and finance world. These are total return, percentage return, and average annual return.
Total return of ROI helps to understand how appropriately you have done the investment by ascertaining the total returns. On the other hand, percentage return ROI is useful when investors need to calculate the size of the investment. The third one ROI which is average annual return, as the name suggests, this is used to calculate the annual returns on any individual investment.
Well, that's the end of today's lesson: What is Return on Investment and how to calculate it. We are sure you might have found all the above mentioned information quite helpful and meaningful. But, if you feel something is left to explain or you need in-depth insights on ROI, you can contact us.