An investor cannot evaluate any investment, whether it's a stock, bond, rental property, collectible or option, without first understanding how to calculate return on investment (ROI). This calculation serves as the base from which all informed investment decisions are made, and although the calculation remains constant, there are unique variables that different types of investment bring to the equation. In this article, we'll cover the basics of ROI and some of the factors to consider when using it in your investment decisions. (Also check out How to Calculate ROI for Real Estate Investments.)
On paper, ROI could not be simpler. To calculate it, you simply take the gain of an investment, subtract the cost of the investment, and divide the total by the cost of the investment. Or:
ROI = (Gains – Cost)/Cost
Investing in Joe's Pizza
For example, if you buy 20 shares of Joe's Pizza for $10 a share, your investment cost is $200. If you sell those shares for $250, then your ROI is ($250-200)/$200 for a total of 0.25 or 25%. This can be confirmed by taking the cost of $200 and multiplying by 1.25, yielding $250.
There are a couple different ways to think about this. The popular one is to picture each dollar invested in this stock paying 25 cents to you. Putting more money in the stock will result in a larger total payout, but it won't increase the ROI. The ROI will be 25% whether $200 grows to $250, $2 grows to $2.50, or $200,000 grows to $250,000. (For more examples of the ROI calculation, take a look at the How To Calculate ROI Video.)
I Just Want the Truth!
Because it is a percentage, ROI can clear up some of the confusion caused by just looking at dollar value returns. Imagine two of your friends, Diane and Sean are telling you about their investments. Diane made $100 investing in options and Sean made $5,000 investing in real estate. Both these numbers will be their return – their profits after costs have been subtracted. With only that information, most people would assume that Sean's investment is the better one. However, without understanding the costs of the investment, we can't make any accurate conclusions about the return.
What if Sean's costs were $400,000 and Diane's were only $50? This would mean Sean's ROI is 1.25% while Diane's is 200%, a clear win for Diane. The dollar value of the return is meaningless without considering the cost of the investment. For this reason, the costs of an investment, both initial and ongoing, are an essential piece of information for any investor. (Learn more about ROI and other ways to value investments; read our Financial Ratio Tutorial.)
ROI and the Investment Rainbow
The ROI calculation remains the same for every type of investment. The variation, and the danger for investors, comes in how costs and returns are accounted for. Here are some commonly mishandled investments.
- Real Estate
Real estate can create returns in two ways, rental income and appreciation. Rental income simply has to be added to the gains as it is realized. Costs, however, come from many different sources. There is the initial purchase cost, taxes, insurance and upkeep.
When people talk about making a 200% return selling their home, they are often making the error of simply using the purchase price and sale price of their while ignoring all the costs in the middle. Or, if it is an investment property, they may be accounting for the rental income and appreciation properly, but neglecting insurance costs, taxes and that new water heater, etc.
Real estate can be an excellent and profitable investment, but the projected ROI on these investments is frequently exaggerated.
Stocks are prey to the same type of omission as real estate. More often than not, investors fail to keep track of their transaction costs. If you make a $100 gain but forget the $20 you paid buying the stock and another $20 selling, then your ROI is grossly inflated. As with rental income, dividend payouts should be added back into the gain column when you want to calculate the ROI.
Collectibles like the Honus Wagner card, Action Comics #1 and the 1933 Double Eagle can sell for millions, making for astronomical ROIs when compared to their original prices. However, collectibles are rarely purchased at their original prices and, depending on the type, have high insurance and maintenance costs that cut the true ROI down to size.
- Leveraged Investments
Leveraged investments pose an interesting problem for ROI. Because they allow the initial investment to be multiplied many times over, they can also generate multiple returns. However, in this case, the incredible ROI that some traders make must be tempered by the risks they take. Leveraging an investment dollar to equal two or three dollars works well when the returns are positive, but losses are similarly leveraged in some of these investments.
With plain vanilla options and basic forex accounts, the most a beginning investor will lose is the price of the option or the balance of the forex account if it stops out. However, it is useful – and sobering – to think of it in terms of the capital controlled. If you lose $1,000 on a forex trade leveraged 10 times, that's a $10,000 mistake – even though it thankfully only cost you 10% of that. ROI can't tell the whole story of leveraged investments. The risk-reward tradeoff is the place to start for that lesson.
Moving Beyond ROI
ROI is a simple calculation that tells you the bottom line return of any investment. The operative word, however, is simple. One major factor that doesn't appear in an ROI calculation is time. Imagine investment A with an ROI of 1,000% and investment B with an ROI of 50%. Easy call – put your money in the 1,000% one. But, what if investment A takes 30 years to pay off and investment B pays off in a month? This is when time periods come into play and investors must look to the compound annual growth rate, or CAGR.
The Bottom Line
ROI is a useful starting point for sizing up any investment. Remember that ROI is a historical measure, meaning it calculates all the past returns. An investment can do very well in the past and still falter in the future. For example, many stocks can yield ROIs of 200%-500% during their growth stage and then fall down to the single digits as they mature. If you invested late based on the historical ROI, you will be disappointed. Projected or expected ROIs on an unproven (new) investment are even more uncertain with no data to back it up. For this reason, Investors must learn about other metrics like CAGR, debt to equity, ROE, and many others to dig into the numbers making up ROI. (For related reading, take a look at Analyze Investments Quickly With Ratios.)
ROI, Return On Investment, is one of the most used methodologies to gauge the possibility of making a profit on a project or business, or even compare several of them, in order to choose the best one.
This is because this formula is very practical to use.
Actually, it’s quite simple:
Return On Investment formula (as a percentage):
ROI = RETURN – EXPENSES x 100
We multiply by 100 so that the value is represented as a percentage, which is easier to understand, but not everyone does this.
So, to break the ice, let’s imagine a return on investment calculation example, merely illustrative.
Pedro, a little boy from a small country town, decided to earn some extra money for the summer vacation, and set up a small bar at the gate of his house to sell lemonade.
- Portable table and chair and insulated coolers borrowed from his father: $ 0.00
- Cardboard, pens and creativity to write advertising and price posters: $ 15.00
- 5 dozen lemons: $ 80.00
- 10 liters of ice cubes manufactured in the home refrigerator using mineral water (competitive advantage): $ 20.00
- 50 liters of mineral water (comp. advantage) to make the lemonade: $ 100.00
- 2 pounds of sugar: $ 5.00
- 300 biodegradable paper cups (ecologically responsible = market positioning): $ 100.00
Total EXPENSES: $ 320,00
With this, it’s possible to produce approximately 65 liters of lemonade (lemon juice and ice also increase the volume!).
This translates into 260 glasses of lemonade, which he wants to sell at $2.00 each, which equals REVENUE of $520.
If he sells about 26 cups a day, he will exhaust his stock in 10 days, which is his goal.
So, putting this simple return on investment calculation example into the formula, we get:
ROI = 520-320×100
ROI = 62.5%
That is, with each invested $ 1.00, the young Pedro gets back an additional gain of slightly greater than $ 0.62 cents.
In other words: for every $ 1.00 invested he finishes his venture with $ 1.62, making the calculation:
$ 320.00 x 1.625 = $ 520.00.
Of course, this is an example of a purely enlightening Return On Investment for those who didn’t yet know the concept.
Below are other return on investment calculation examples that may be best suited for those who want to better understand what financial management is.
See also: How to start a home business: The 4 VRIO questions
Return On Investment Calculation Example’s
It’s important to remember for anyone who wants to learn how to calculate Return On Investment for projects or companies that a common practice is: To define 3 scenarios.
Pedro simply assumed that he would sell everything he produced in 10 days, but what if it rained during that period, or on the contrary was so hot that his stock ended in 5 days?
So, let’s include this practice in the following return on investment calculation example.
Return On Investment example in a print media marketing campaign
Imagine a shoe brand that has average sales of 100,000 pairs in its summer launches every year.
This brings revenue of $ 1,000,000.00 in this period, which corresponds to a profit of $ 200,000 (around 20%), every year in the summer.
The marketing director decides to launch a new marketing campaign by posting ads in fashion magazines, all produced by their advertising agency.
The total cost of this campaign is $ 200,000.00.
- Pessimistic: 20% increase in sales = Profit of $ 240,000.00
- Average: 30% increase in sales = Profit of $ 260,000.00
- Optimistic: 40% increase in sales = Profit of $ 280,000.00
Note: In this case, the gain from the marketing campaign should be measured by the increase in profit, not total revenue, to justify the investment.
Let’s put it in the formula and see if the the board and chairperson approve the campaign:
- Pessimistic Return On Investment example – Calculation: (240 – 200)/200 x 100 = 20%
- Average Return On Investment example – Calculation: (260 – 200)/200 x 100 = 30%
- Optimistic Return On Investment example – Calculation: (280 – 200)/200 x 100 = 40%
Apparently they will approve this marketing campaign based on this return on investment calculation example. But what if these scenario forecasts didn’t materialize?
This is a risk inherent in every business, and that’s why your sales forecasts should be the best possible. Therefore, they should be based on reliable historical data and statistical software that signal the increase or decrease in demand as a result of marketing investments, among other factors .
Return On Investment example in an online media campaign
The advantage of online campaigns is that you can keep track of the Return On Investment. If the desired scenarios don’t go your way, you can quickly change your campaigns to adjust your investments across different media to improve results.
Look at this return on investment calculation example in 3 different types of marketing investments in online media:
Imagine a company that provides cloud-based BPM modeling software through SaaS, that is: with a monthly fee users are entitled to use the software.
To advertise the business they opt for 3 online strategies:
Create articles for a blog that addresses issues of interest to their audience. They lure customers to a landing page to get them to share contact information such as email and phone in exchange for differentiated materials and experiences, such as e-books or trials.
Ads on Google Ad Words:
Which will route leads to these same landing pages, offering e-books and trials.
Ads on Facebook Lead Ads:
A Facebook integration that allows users to fill out forms in exchange for the same materials and experiences mentioned above.
In this SaaS company, sales funnel analysis shows that 20% of leads to their landing pages fill out the registration form.
So, of these 20%, 40% react positively to emails with information about their BPM tool and of these 40%, another 40% end up buying the product, when they’re contacted by telephone.
Thus, the final conversion rate is 3.2% or (0.20 x 0.40 x 0.40), for each lead that arrives at a company landing page and consequently fills out the form.
For example: out of every 1,000 people who reach their landing page, 32 end up buying the product.
The company knows from its historical marketing investment data over the years that to refer 100 leads to a landing page, it’s necessary to invest individually in each option:
- $ 200 in Content Marketing
- $ 240,00 in Facebook Lead Ads
- $ 300.00 in Google AdWords
(NOTE: this data is totally hypothetical and doesn’t indicate any tendency towards particular investments, they are mere examples!)
As the company’s average product cost is $ 100, this means that 100 leads sent to a landing page will generate, on average, 3.2 sales conversions, that is, a revenue of $ 320.00 (3.2 x $ 100.00).
Therefore, by applying this value in the formula, we can discover the ROI of each investment in social marketing:
- Content Marketing = 320 – 200/200 x 100 = 60%
- Facebook Lead Ads = 320 – 240/240 x 100 = 33.3%
- Google AdWords = 320-300/300 x 100 = 6%
So, after realizing that in this hypothetical return on investment calculation example Content Marketing is more advantageous, the company invests 50% of its budget in this, 30% in Facebook and 20% in Google.
Because after a month of making these investments, the company can analyze the conversion data with the help of analytical tools and other features offered by these media companies themselves and know exactly what the return and conversion rate of each strategy is, recalculating their Return On Investment and reallocating funds.
So, what do you think of these Return On Investment examples to define marketing investments?
Does your company use other types of investment analysis, such as IRR or Present Value? Tell us in the comments!