What Is Return on Investment (ROI)?
Return on Investment (ROI) is one of the most fundamental and widely used performance metrics in finance. It measures the amount of return, or profit, on an investment relative to its cost. Expressed as a percentage, ROI provides a simple, universal way to evaluate the efficiency and profitability of an investment. Whether you are a business owner deciding on a new project, a marketer evaluating a campaign, or an individual investor comparing stocks, a ROI calculator is the essential first step in making data-driven financial decisions.
The ROI Formula Explained
The formula for calculating ROI is straightforward and intuitive:
- Initial Investment: This is the total cost of the investment, also known as the principal.
- Final Value of Investment: This is the value of the investment at the end of the period, including any gains or dividends.
- Net Profit: The difference between the final value and the initial investment.
For example, if you invest $1,000 in a stock and sell it a year later for $1,200, your net profit is $200. Your ROI would be `($200 / $1,000) × 100% = 20%`.
How to Use and Interpret ROI
The power of ROI lies in its simplicity and versatility. It provides a clear, standardized measure that can be used to compare the profitability of vastly different types of investments.
- Positive vs. Negative ROI: A positive ROI means the investment generated a profit, while a negative ROI indicates a loss.
- Comparing Investments: If you are choosing between two investments, the one with the higher projected ROI is generally the more attractive option, assuming similar levels of risk.
- Limitations of ROI: The primary limitation of this simple ROI calculation is that it does not account for the holding period of an investment. A 20% ROI over one year is far better than a 20% ROI over five years. To compare investments with different time horizons, it's essential to calculate the annualized return. You can do this with our more advanced Average Return Calculator, which calculates the Compound Annual Growth Rate (CAGR).
For a comprehensive understanding of various investment metrics, resources from reputable financial education sites like Investopedia offer detailed guides and examples.