Return on Investment or ROI is a performance evaluation criteria, used to compare different investment options.
It compares the efficiency of return generation of different investments on a simple formula:
ROI = (Profit from Investment – Cost of Investment) / Cost of Investment
Thus, ROI is arrived at by dividing the net profit from an investment by cost of investment. This value is defined in terms of ratio or percentage. This ratio or percentage is then compared with ROI from other investments to compare which one is better.
For example, Let’s say someone invested Rs. 10,000 in an FD for 1 year and it matures at Rs. 10900. Thus his ROI will be (10900-10000)/10000 = 9%. Now, let’s say he invested similar amount (Rs. 10,000) in shares of a growing company in 2014 and sold them in 2018 at Rs. 13,000. The return on investment will be (13000-10000)/10000 = 30%.
Easy to compare right? (Actually, No. Please read the holding time factor below)
Why ROI is popular?
Return on Investment (ROI) is one of most popular metric to evaluate performance of any investment. The reason it is popular is because of it’s simplicity and wide applications. The calculation as you can see from the formula above is easy to do and simple to understand.
Moreover, ROI is represented in percentage or ratio, which makes it easy to use for investment comparison. This numerical comparison makes the comparison easy even for a layman investor. You can simply eliminate those investments, where ROI is not what you are looking for or not upto the mark as compared to other investment options available.
There are different ratios that you can consider for valuation purpose of any investment, but ROI (& ROE) are the ones that tell you which investment to choose.
Factors to consider for Return on Investment
The issue is, it is not as simple as just taking the final value of your investment and subtracting the purchase price to the value to return you made from the investment. There are many factors involved which needs to be considered to evaluate the right amount.
Holding Period: Holding period is the total time of actually owning that investment. To accurately calculate ROI for any investment, it needs to be calculated for similar holding period.
For example, if one of the investment was held for 1 year and other one is for 2 years, then the return from 2nd investment needs to be divided by 2 to calculate it’s 1 year return.
The reason this factor becomes important is because certain investments give higher returns only when held for certain amount of time, like Fixed Deposits (FDs). Then there are those where you know the final sale price only when you sell them, like mutual funds, stocks etc.
Taking the example above, in the 2nd investment the annual rate of return to proper calculation of ROI will be 30% return divided by 4 ( holding period of 4 years) and thus the return will be ~ 30/4 = 7.67 %. Now the ROI of both the investments can be compared in rightful manner.
Taxation: Earlier, barring a few investments, there was either low or no tax on investments or they were taxed in same bracket. But, now different investments are taxed differently.
Which means, the gains generated by such investments need to be calculated post taxation. Like interest earned on Fixed deposits is different than tax on debt fund vs tax on short term holding of stocks.
Cost of Ownership: This refers to the expenses you incurred for holding the asset/investment. For example, in case of stock and shares it is brokerage & STT paid, as well as demat account expenses ( however minuscule). Similarly, for real estate it is maintenance, property tax etc.
All the expenses which are incurred due to ownership or investment are cost of ownership. They need to be accounted for while calculating the return on investment.
ROI is a useful efficiency measurement tool. But it is historical. Which means, it doesn’t tell about future of that investment. Hence, you need to use ROI along with other financial ratios to evaluate any potential investment option.
But, what ROI does effectively portray is actual profit that you earned from any investment. This knowledge you can use to have holistic view about potential of different avenues and not to judge the investments from only final sale price.
Return of investment forms part of important financial ratios that you need to understand for fundamental investment in stock market. You can know about them by signing up for free introductory 5 email based course.