Return on investment (ROI) is a financial metric that evaluates the profitability of your investment. It’s a ratio of returns (net profit or loss) relative to the investment cost.
The higher the ratio, the greater the returns will be. Although ROI is a ratio, we express it as a percentage for easier interpretation.
This guide will reveal how to calculate ROI (using examples), interpreting the calculations, and the benefits of ROI.
Regardless of your industry or size of business, being able to calculate ROI is extremely important for your business.
What’s more, knowing if your business is earning its money’s worth is an essential concept that business owners need to understand so they can strengthen their financial success.
When you calculate your ROI, you’ll better understand how your company is doing. Also, you can identify areas that need improvement to ensure you reach your goals. Let’s dive in.
Calculating Return on Investment (ROI): ROI Formula
Calculating ROI is quite simple because there’s a general formula for that.
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To calculate ROI, divide the net profit you get from an investment by its cost and multiply by 100 to represent it as a percentage.
Here are the two ways to represent the ROI calculation formula.
Here’s another method you can use to calculate your ROI.
Next, let’s work out ROI in a few examples.
Examples of ROI calculations
Example 1: Assuming that you’re a real estate investor. You have the choice of buying houses A or B.
House A goes for $270,000 and comes with an additional cost of $30,000 in the renovation. House B goes for $240,000 but with an additional $10,000 on repairs.
If you buy house A, you plan to resell it for $350,000. If you buy house B, you intend to resell it at $290,000. Which investment opportunity should you opt for?
Solution
Return on investment for house A = (Net profit/ Cost of investment) * 100;
Net profit = Reselling Value - Total Investment cost = (350,000 - [270,000 + 30,000]) = 50,000;
Cost of investment = 300,000
ROI = (50,000/ 300,000) * 100% = 16 ⅔ %
Return on investment for house B = (Net profit/ Cost of investment) * 100;
Net profit = Reselling Value - Total Investment cost = (290,000 - [240,000 + 10,000]) = 40,000;
Cost of investment =250,000
ROI = (40,000/ 250,000) * 100% = 16%
House A is a better investment opportunity because it yields a higher ROI than house B.
A good way to weigh your options when deciding between potential ROI is to compare the net profit and cost of renovation. If the potential ROI is higher with a certain house, then that should be your preferred investment option. This is one of those real esate investment best practices that anyone who is looking to invest in property should keep in mind.
Let’s look at a more complex example than this one.
Example 2: Assume you buy 2000 shares in company X at $ 15 per share. Three months later, you plan to sell the shares for $20 each, and you’ll incur a total of $150 as the trading fee. Over those three months, you earned dividends of $1000. What will be your ROI if you sell the shares?
ROI = [Net Profit (Net Return on Investment)/ Cost of Investment)] * 100%;
Net Profit = (Selling value + additional revenue) - (cost of investment + additional expenses) =
= [(20 × 2000) + 1000] - [(2000 × 15) + 150] = 10850;
Cost of investment = 2000 × 15 = 30,000;
ROI = (10850/ 30,000) * 100% = 36 ⅙ %
In the two examples above, ROI is positive, which translates to profit. Let’s see an example of negative ROI.
Example 3: The initial investment of a business venture was $125,000. The revenue from the venture is $100,000. What’s the ROI for this investment?
ROI = {[Final Value of Investment (FVI) − Initial Value of Investment (IVI)]/Cost of Investment} * 100%;
FVI = 100,000;
IVI =125,000;
Cost of Investment = 125,000;
ROI = [(100,000 - 125,000)/ 125,000] * 100% = - 20%;
ROI = - 20%;
The business made a loss of 20% of the amount they invested.
Interpreting ROI calculations
ROI calculations gauge the profitability of different investment opportunities by showing the percentage of returns each investment will yield.
But what exactly does that percentage represent in terms of numbers or figures?
Let’s use the ROI in Example 2 above — 36 ⅙ %. Since the ROI is positive, you get 36 ⅙ % of the investment cost as net profit. In this case, you get 36 ⅙ % of 30,000 as net profit.
If the percentage could have been a negative value, it would translate to losses in your investment.
In short, the figure you get from ROI calculations is the percentage profit or loss of the investment cost.
Positive ROI means that the total revenue you’ll get exceeds the total cost of the investment. When the ROI is negative, the investment is generating a loss.
Tip: For accurate percentage figures in your ROI calculations, include total returns and costs tied to the investment.
Annualized Return on Investment (AROI)
Over time, this basic formula shows us how to calculate ROI without considering the investment time frame. Annualized ROI offers a remedy for that by including how long the investment takes.
It represents the yearly average returns you’ll get from an investment — no approximations or guesswork. Plus, annualized ROI lets you calculate returns for periods less than a year. Let’s check out the formula and use some simple calculations to apply this formula.
here n = Number of years of investment
If the investment period is less than a year, divide the number of months by 12 to get a fraction of a year.
Grab your calculator, and let’s solve some simple examples.
Example 1: Assume you’ve invested in PPC ads, and after three months, it generates a 9% ROI. What’s your annualized ROI?
Convert three months to a fraction of a year = 3/12 =¼;
AROI = [(1 + ROI) 1/n - 1] × 100%;
Where n is the number of years = ¼=0.25;
= [(1+ 0.09)1/0.25 - 1] × 100% = 41.16%;
Annualized ROI = 41.16%
Example 2: An investment in stock Q generates an ROI of 40% over four years, while another investment in stock R generates 20% over two years. Which investment is better in terms of ROI?
AROI for Q = [(1+0.4)¼ - 1] × 100% = 8.78%;
AROI for R = [(1+ 0.2)1/2 - 1] × 100% = 9.54%;
Stock R has a higher annual ROI than Q, making it a better investment.
Annualized ROI is superior to the basic formula because it measures how the investment has shrunk or grown over a year.
It also shows the average annual returns of each year during the investment period. And above all, you can use it to compare the performance of investment opportunities with different time frames.
ROI Calculator
If following up on how to calculate ROI is too much task for you, this section will suit you perfectly.
You can access a free online ROI calculator where you just feed in the figures and get your ROI immediately.
Here are two calculators you can use.
Calculator.net ROI Calculator
- Visit https://www.calculator.net/roi-calculator.html;
- You’ll see a calculator page. On the Amount, Invested Tab feeds in the total investment cost.
- On the Amount Returned tab, enter the final value of the investment, which is the gross profit.
- Enter the investment time. You’ll either use the exact dates of investing and measuring returns (date, month, and year) or input the investment length in years. Click Calculate at the end of the page.
- At the right side of the calculation page, you’ll see the Result page where you’ll access Investment Gain in dollars, ROI in percentage, Annualized ROI in percentage, and the Investment Length in years.
- Below the Result page, you’ll see a pie chart showing the percentage you invested and the profit you got from your investment.
Here’s another calculator.
CalculatorSoup ROI Calculator
- Visit https://www.calculatorsoup.com/calculators/financial/return-on-investment-roi-calculator.php;
- You’ll see a page to fill in your investment details. In the Initial Investment tab, enter the total cost of your investment.
- Fill in the Final Value tab with total revenue (gross profit) from the investment.
- Skip the Total Income and Total expenses tabs in the Optional section since you've filled the first two tabs. The Length of Investment tab enters the investment period in years or months (or both if applicable).
- Click Calculate below and on the right side of the Optional section.
- You’ll see your basic ROI and Annualized ROI in percentage in the Answer tab, followed by a step-by-step calculation.
- At the end of the page, you can copy the link to your ROI calculations.
What is ROI Used For?
As mentioned earlier, ROI reveals the returns of an investment and compares the value of different investment opportunities, which helps to make informed decisions.
But how does it apply to your business’s daily routine?
#1. Use ROI when purchasing a new business tool
Adding new equipment to your business can be a step in the right direction, but you must buy it wisely. Calculating ROI when purchasing a tool allows you to gauge its value in your business, which can be helpful in future investments in a tool.
#2. Use ROI when hiring new employees
When hiring, calculating ROI answers the question, “are the new employees increasing or decreasing my business’s profitability?”
Interestingly, you’ll also know the kind of people to fire from your business.
#3. Use ROI when adding a new department
Adding a new department to your business is a smart move only if it increases business profitability. That’s why it’s crucial to use ROI calculations and eliminate guesswork.
Generally, use ROI in all business investments to make sure you choose the best opportunities with the highest potential to profit.
#4. Use ROI in marketing
Here, you calculate ROI to determine the paid marketing campaigns yielding the greatest returns for your business and those dragging you down. That way, you’ll know the marketing campaigns to focus on and those you need to abandon.
The formula for ROI calculations in marketing may look like this:
[(Revenue gained from the marketing campaign-Cost of marketing campaign)/Cost of marketing campaign] × 100
OR
{[(Number of leads ×Leads-to-customer rate × Average sales price)- Cost of Marketing]/Cost of Marketing} × 100
Where:
Number of Leads: How many people converted to potential customers or leads from your campaign?
Lead-to-customer rate: What percentage of leads became actual customers? If 30 out of 150 leads become customers, your lead customer rate is (3/150) × 100 = 20%
Average sales price: This is the average price of your product if you occasionally have discounts or any other offers that alter pricing in any way. If you don’t change the price in any way, use the constant price of your product.
Cost of Marketing: How much did you spend when promoting your product? When identifying this figure, factor in all the expenses related to the marketing campaign, including wages for people involved in the campaign.
Best Practices of Measuring Marketing ROI
Calculating ROI in marketing may seem tricky since it requires linking hard revenue figures with marketing content like blogs and videos.
To give you an upper hand in this, consider the following factors to get accurate ROI measurements and gauge the success of your campaign.
Non-financial Returns
Did you gain any secondary benefit from your campaign? Like unexpected traffic boost, social media engagement, or other non-finance-related bonuses? If so, this could still boost brand awareness. Therefore, consider them to get an accurate ROI.
Time
How long did it take to create the marketing content? What time frame do you measure the results with?
Production Costs
How much did you spend on the marketing materials? Are there any services, supplies, or software adding up to the production costs?
How much did you pay the people involved in creating the marketing content? Add all the costs to get accurate ROI calculations.
Promotional costs
Did you spend anything on promotion? Maybe Facebook ad costs, PPC, or any other promotion expenses?
Page Analytics
Monitor your online ad campaigns in Google analytics using a tracking URL to determine if your marketing campaign drives traffic to your landing page. Here’s how to create a tracking URL in Google Analytics.
Advantages of ROI
Easy to calculate
Few figures (the benefit and cost) are necessary to calculate ROI, and the formula is easier to understand. Plus, when calculating it, one rule stands for all businesses — ROI must be positive to yield better results from an investment.
Comparing investment opportunities
ROI is critical when evaluating investment opportunities in your business. By comparing the profitability of different investments, you can make the right decisions for better results in your business.
For instance, in Example 1 above, we compared the profitability of investing in houses A and B. The ROI for house A was 16 ⅔% and 16% for house B. House A was the better investment opportunity because it had a higher positive ROI.
Disadvantages of ROI
ROI doesn’t consider the investment period
The basic ROI formula doesn’t account for time in calculations.
Assuming investment B yields an ROI of 35% while investment C produces an ROI of 20%, you can't conclude that investment B is better than C unless you consider the time frame.
B might take ten years while C 1 year to generate the ROI. Annualized ROI formula fixes this problem.
ROI doesn’t consider investments risks
Investment opportunities come with risks. If you depend on the ROI number without evaluating the risks, you may get unexpected results.
ROI calculations might show you that investing in pay-per-click ads will generate a higher revenue than the cost. But if you don’t consider that an internet user might just click on the displayed advertisement without buying your products, the eventual outcome will be disappointing.
You can easily exaggerate ROI figures if you don’t include all the costs tied to the investment
Take, for example, when buying a new machine for your business. You can easily overlook maintenance expenses by focusing on the benefits it’ll bring.
These expenses can add up over time, and failure to include them in your ROI calculations will exaggerate the figures.
ROI only emphasizes financial gains
Similar to other profitability metrics, ROI focuses on financial gains without considering secondary benefits like social and environmental impacts.
Frequently Asked Questions
Can Any Business Use ROI In Evaluating Investment Opportunities?
All kinds of organizations, big or small, online or offline, can use ROI to compare investment opportunities.
How Accurate Are ROI Calculations?
ROI figures are estimates whose accuracy increases with the preciseness of the investment costs.
Calculation ROI – Why It Matters For Your Business
The ROI metric helps you determine how efficiently your company is, using money invested by shareholders to generate profits.
Remember that calculating the ROI and production costs involves many essential rules that must be followed to ensure you get the best outcome.
Nearly all business decisions require the knowledge of ROI. That also ensures that you can tell whether your efforts are yielding the results you desire or not. This way you can properly optimize your company’s profitability. For any business to succeed, understanding the significance of Return on investment is crucial.
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