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ROI full form is the return on investment. It refers to the profit you earn in return on your invested money.
You try to save the money you earn so that you can fulfil your present needs and achieve larger financial goals in future. But saving money is not enough, you need to invest it and earn a good return on investment (ROI) on it. It can be difficult to achieve long-term goals if you are not investing regularly.
Investing allows your money to grow over time with the power of compounding. A good return on investment allows you to beat inflation and build wealth so that you can replace your income during your retirement period.
What is Return on Investment (ROI)?
ROI or return on investment is a measure of the growth of your invested money. It is a popular indicator which estimates the ratio of money received from an investment over the money invested. Return gained on two different investments estimated over the same period is comparable. Thus, you can also use ROI to compare different investments.
For example, if you invest Rs 100 and one year later receive Rs 110, your money has grown 10% in one year. In other words, your ROI of Rs 100 has been 10% per year.
ROI also measures the performance of the investment options.
For example, if you have two different options you can invest your savings in, ROI will help you identify the profitable option between them. Look at the ROI of both investments for the same period and you can invest for a higher rate of growth.
Thus, in the investment world ROI is one of the methods to ascertain the profitability of an investment. Other popular methods similar to this concept are net present value (NPV) and internal rate of return (IRR).
You can use these metrics as well to compare investment options and choose a better one. Return on investment for a fixed-income investment will tell you the return you can expect from the investment.
Formula to Calculate Return on Investments
Return on Investment helps you compare the income received from the investment that you have with the cost of the investment.
Below are the formulas for ROI calculation:
Formula 1:
ROI = (Investment Value at Maturity - Invested Value) / Invested Value x 100
Formula 2:
ROI = Net Gains / Invested Value x 100
Where,
Net Gains = Final Value of Investment – Invested Value
- ROI can be positive, negative, or zero
- ROI is always denoted as a percentage
Example of ROI Calculation
Suppose you invest Rs 2 lakhs in a savings plan for 10 years and receive Rs 4 lakh at the end of it and Rs 15,000 every 5 years, ROI from the savings plan will be:
ROI = ([(4 lakhs – 2 lakhs) + 15,000 x 2] / 2 lakhs) x 100
= 115%
Although, 115% looks huge, keep in mind that this is an absolute return of 10 years. This ROI will not be comparable to a bank FD giving 8% p.a. or any other annual ROI figure.
When converted into an annual compounded return ROI of the savings plan will be 7.96% p.a. which is comparable to the ROI of a bank FD.
Steps to Calculate ROI
Now that you know the meaning of ROI, you must be wondering how to calculate it. You can estimate ROI in two easy steps:
- Estimate the Net Gains: Calculate total income including maturity proceeds and any intermediate payments like bonuses or dividends. Deduct your initial investment amount from this.
- Estimate the Ratio (ROI): Divide the amount in step one from the initial investment amount and multiply by 100%. This is your percentage ROI.
How to Compare Different Investments?
Different approaches may be considered when it comes to comparing the ROI of different investment options. You may use the following methods to compare two investments together:
-
Pay-Back Period
It is the simplest way to compare two investments. It helps you to determine in how much time your investment will be recovered.
- It can be calculated as Payback Period= Total Investment/Cash flow per year
- The lower is the payback period, the better is the investment.
- It is calculated in years.
For example, you have invested Rs 1,00,000 and the return per year is Rs 10,000 then PBP will be 1,00,000/10,000 = 10 years.
-
Time Value of Money (TVM)
The money that you have today may not be worth as much a year later. The value of money today will be worth more than tomorrow. This is time value of money.
Future Value= Present Value x (1+R)N
Learn more about Time Value of Money.
-
Net Present Value (NPV)
This is the extension of the concept of the time value of money. It expresses the present value of all the future cash flows that you will receive from your investment.
- To calculate NPV, a ‘discounting rate’ is used.
- A positive NPV indicates that the investment can be considered
- NPV uses the concept of the time value
NPV= ΣRt / (1+ i)t
Where Rt is the value of cash flow at the time ‘t’ and ‘i’ is the discount rate.
This method allows you to evaluate multiple cash flows, coming in or going out, at different points in time.
Learn more about Net Present Value (NPV).
-
Internal Rate of Return (IRR)
It is a method in which the return is calculated excluding all the external factors, such as inflation rate, bank rate, etc.
Under this, the NPV is considered to be 0.
IRR = Ct / (1+ r)t- Co
Learn more about Internal Rate of Return.
Using these ROI estimation ways, you can now evaluate different investment options before investing. However, do keep in mind that most of these investments are bound to the market scenarios as well. Thus, looking only at ROI is akin to looking only at one side of the coin. Better have a look at the market conditions as well before concluding.
FAQs on Return on Investment (ROI)
ROI can be used to assess the profitability of an investment, a business opportunity or a project. A positive ROI is an indicator of a profitable venture. However, for better decision-making and comparison with similar investment options, you should consider estimating annual ROI.
Annualised ROI is also comparable to the inflation rate.
Basic ROI calculation gives a measure of the returns without considering the factor of time. While time plays an important role in investment valuation. For instance, if upon investing Rs 1000, investment ‘A’ gives Rs 2000 in 2 years and investment ‘B’ gives Rs 2000 in 1 year, Investment ‘B’ is better. However, if the amounts are a close match, it’ll be difficult to assess the better investment.
Annualised ROI can bring investments with different investment tenures on the same comparable plane.
Leverage acts as a catalyst with return on investment (ROI), i.e., profitable investments will have an amplified ROI while loss-making investments will experience amplified losses. For example, you invest a total of Rs 1 lakh in a fund and receive Rs 2 lakhs at maturity after 5 years. If you had only used Rs 50,000 out of your pocket and borrowed Rs 50,000 at 8% p.a. (simple interest). You are leveraging investment. In this case, your ROI will be:
- 260% with leverage, as you end up paying Rs 20,000 out of your profits towards interest but gain an additional Rs 80,000 (total capital gain Rs 130,000)
- 100% without leverage, and your total capital gain remains Rs 50,000 only
ROI is a simple method of calculating the profitability of any investment. However, in its simple form, it is only good for estimating whether the investment is profitable or not. Since the formula does not consider time as a factor, you will have to assume that investments offering similar ROI in less time will be better.
A good ROI is the one which resonates with the investment risk. For example, stocks are riskier than bank deposits. Therefore, a good ROI on stocks must be higher than FDs. Similarly, you can align your ROI objective to your risk appetite.
Being profitable is the primary objective of a business venture. Thus, a business must have a positive ROI. A business with a negative ROI cannot sustain itself for a long time. Thus, ROI plays a very important role in the evaluation of a business.
Disclaimer: This article is issued in the general public interest and meant for general information purposes only. Readers are advised to exercise their caution and not to rely on the contents of the article as conclusive in nature. Readers should research further or consult an expert in this regard.
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