Return on Investment (ROI)
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Definition of Return on Investment (ROI):
An investment’s return on investment
is a measure of its profitability—the amount earned divided by the investment multiplied by 100 to convert to a percentage.
Investors use ROI to measure and compare how profitable the investments are. For example, which investment is more profitable—a $1,000 investment that earned $100 or a $500 investment that earned $60? Assume each investment was for one year. The $500 investment is more profitable when measured by its return on investment because it had a 12 percent return. The $1,000 investment had a return of 10 percent. The calculations are below:
x 100 = ROI
The return of investment for the $1,000 investment is:
x 100 = 10%
The return on investment for the $500 investment equals:
x 100 = 12%
Using the ROI to measure investments has limitations. In the above example, it is assumed that each investment is for one year. What if the $1,000 investment yielded $100 in one year, but the $500 investment earned $60 after two years? The $1,000 investment has a higher average annual return on investment (10% vs. 6%).
Another shortcoming is the return on investment fails to consider risk. Assume that an investor is considering the two investments above, and 10 percent and 12 percent are the projected returns on investment. However, the 10 percent return is a very safe investment, and the 12 percent return is a very risky investment. The safer investment may be the better investment given the investor’s adversity to risk.
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