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Return On Investment (ROI)

What is ROI?

Return on investment (ROI) is a key concept for management of money that can be applied to business objectives as well as personal finance. In a basic sense, it's a calculation that tells an investor how well an investment is performing over time. However, the concept, in addition to the results the calculation of ROI produces, can vary somewhat depending on the variables taken into account and what time horizon is considered in making the calculation.[1]

How To Calculate ROI: The Basic Formula

The basic formula for calculating ROI is: ROI is equal to net profit or loss, divided by cost of investment. Mathematically, that is often expressed as:

ROI = (Gains from Investment - Cost of Investment) ÷ Cost of Investment

The definition of ROI generally looks and seems straightforward, and can be. However, the calculation of ROI will produce different results depending on how the terms of the equation, "cost of investment" or "gains from investment," are defined.[1]

ROI can be calculated as a final value or a projected value, the latter also known as "expected return on investment." A projected return can be an educated guess of return, based on known and estimated future information. The final value will be based on actual returns once they have been verified.[2]

Some Variations On The Theme Of ROI

There are several formal methodologies used by businesses for calculating ROI, which include internal rate of return, net present value, payback and profitability indices. For practical purposes, however, a few basic conceptions that ROI follows:

1) Total Return

The total return expresses how much an investment has produced over a given period of time in a nominal money amount. This will take into account all forms of income from the investment, including any capital gains or losses, and any dividend or interest income.

2) Percentage Return

The percentage return can help investors understand how well an investment did in relation to the original amount they invested. This will equal the total return divided by the investment amount, multiplied by 100.

3) Average Annual Return

The average annual return uses the percentage return, but it also considers how long the investment is held. The calculation for the annual average return is:

Annual Return = (Simple Return Percentage +1) (1 / Years Held)-1[3]

Cash Flow Method

To account for possible changes over time, business investors often prefer use of cash flow methods that show return over a series of future periods, considering any possible changes in returns from year to year.[4]

Accounting For Costs

As with businesses, both individual and institutional investors will face costs in doing the business of managing their portfolios. These will include items like trading fees, taxes and interest charges.

To simplify this process, traders can subtract the costs from the final (i.e. "current") value of their investment when it is sold, and can conceive of the ROI calculation in this manner:

ROI = Current Value of Investment – Initial Value of Investment ÷ Initial Value of Investment

ROI Errors

ROI figures, particularly within expected ROI, may be subject to errors. These may have to do with miscalculation of future profits or a neglect to include certain risks or costs associated with an investment.[5]

Currency Trading Profits And Costs

ROI in currency trading will take in all of the basic factors mentioned above. Naturally, gains from investment, or "current value," will depend on market conditions and the individual trader's ability. The costs in currency trading will include standard investment costs such as capital gains and income taxes. With trading itself, traders will be subject to broker commissions and spreads.

In some cases, commissions and spreads will be rolled into a single cost that is inserted into the spread (the difference between the bid and ask prices). In other cases, brokers may separate commission and spread costs in order to give more transparency to total trading costs for their clients.

ROI And Capital Efficiency

One of the beneficial elements of ROI is that it addresses the concept of capital efficiency. Operating efficiently is a key part of being successful as a business or a participant in the futures, forex or equities markets. However, the term's working definition varies depending upon whether one is scrutinising the performance of corporations or investors.

Getting the most from available financial resources is a key aspect of achieving sustainable profitability. Even though the derivation of capital efficiency differs a bit from ROI, it remains an invaluable tool for placing an investment's costs and gains into a manageable context.

Traders And Investors

For traders and investors, it's important to optimise the upside potential of the risk vs reward relationship. Among the best ways to accomplish this feat is through maximising the efficiency of any and all market-based expenditures.

In this instance, capital efficiency is defined as being an informal ratio that divides output by expenditure.[6] While this calculation is similar to that of standard ROI, it has a unique strategic value to traders and investors.

The capital efficiency formula gives the user a quick, approximate view of how effectively funds are being utilised. High degrees of capital efficiency suggest that a strategy is potentially robust, while low readings point out an added degree of risk. As a general rule, the greater a trader or investor's capital efficiency, the greater the ROI.

Business Operations

Corporations view capital efficiency from a slightly different perspective than do traders and investors. From a business standpoint, the term is relative to incurred expenses compared to money being spent in production.[7] Once again, this concept is reminiscent of the conventional ROI formula. However, the key difference is that a business's capital efficiency is predicated upon expenses and production costs exclusive of returns.

The key driver of corporate capital efficiency is the degree of assumed expenses. A few common examples of such expenses are liabilities stemming from debt service, taxes and insurance policies.

In the event that these costs get too high, significant capital resources are taken away from the production of goods and services. As a result, profitability suffers as investment expenses grow and output shrinks due to a lack of operating funds. For businesses, sub-par capital efficiency means a lagging ROI.

Cash Flow Method (CFROI)

Cash flow return on investment (CFROI) is a fundamental indicator that focuses on a company's cash value. Many investors prefer CFROI as it directly measures the percentage of return on a firm's existing real cash flows.[8]

CFROI is calculated by taking the following elements into consideration[8]:

  • Gross Investment (GI): The total capital invested in existing assets, adjusted for depreciation and inflation.
  • Gross Cash Flow (GCF): The current year's cash flow earned from investments. This figure represents a firm's after-tax income with depreciation and amortisation added.
  • Expected Life Of Assets (n): N stands for the variable earning life of assets from the time of original investment.
  • Expected Value Of Assets (SV): SV represents the salvage value of all assets at the end of their operational lifespan.

A firm's CFROI is the internal rate of return (IRR) of these four cash flows, adjusted in current dollar terms.[8] Through focussing on all revenue streams, the CFROI expresses the evolving value of investments, hard assets and cash flows.

Summary

ROI is an important concept for investors whether they are making business investment decisions or managing financial portfolios. Ultimately, it can reveal whether a particular investment appears worthwhile or not.

The basic calculation is simple. However, it can be modified according to varied interpretations of its component cost and gains from investment, in addition to according to time horizons used for its calculation. Once investors decide the relevant values of these components for each investment, they will certainly benefit from using the concept to evaluate results and potential for investments in any and all asset categories.

This article was last updated on 17th July 2020.