Return on Investment (ROI)

What is Return on Investment?

Return on investment, often simply called ROI is the ratio of profit to the cost of an investment. ROI is used by businesses and individuals to evaluate the efficiency of risking their capital.

A high ROI, relative to similar alternatives, indicates that an investment may be worth the risk. A low ROI, relative to similar alternatives, suggests that the capital could be used more efficiently in other ways.

ROI is applicable to any investment, including real estate, fine art, stocks, etc.

How is ROI Calculated?

ROI = Net Profit / Net Cost

• Net Cost = Cost to Acquire Asset + Transaction Costs + Financing Costs + Other Costs
• Net Profit = New Value of Asset - Net Cost

Return on Investment In Real Life

Investor AAA buys 100 shares of stock in company XYZ at $10 per share. The transaction is made on margin so that AAA only needs to use $500 of personal capital and his broker loans him the remaining $500. The broker is charging an annual percentage rate (APR) of 5% and a $5 fee for the full transaction.

Exactly one year later the stock has climbed to $20 per share and AAA sells all 100 shares. The out-of-pocket cost of acquiring the asset was $500 for 100 shares of the stock, plus $5 transaction fee for the round trip of the trade, and a $25 financing fee for the loan from the broker, for an investment cost of $530 = $500+$5+$25.

The net profit of the investment was $20 per share on 100 shares, which is $2000 =$20x100, minus the $500 loaned from the broker, the $500 of AAA’s own money, and $30 for the transaction and financing fees, for a net profit of $970 (=$2000-$500-$500-$30). The ROI of the investment in XYZ is therefore 183%=$970/$530.

Limitations to ROI as an Effective Metric

ROI has some limitations as a metric when making comparisons, including risk and opportunity costs. The risk profile of an investment must be considered to make a fair comparison of ROI values.

In the example above, the ROI of 183% for one year is very high, which suggests that company XYZ was a very risky investment. The gains may have been a function of favorable news or events, like government approval of a drug or a technological breakthrough, but the stock could have dropped dramatically due to the news that affected XYZ negatively. If AAA had invested in another stock with a low-risk profile, it would be unfair to compare the two investments, akin to comparing apples to oranges.

Also, ROI does not consider the amount of time it takes to achieve a profit, which is the time that the capital could be used for other investment opportunities. For example, if investor AAA above had to maintain the same position for 10 years to achieve the same results, the ROI would drop because of finance costs, and the annualized ROI of that new ROI would decrease by a factor of 10. The 10 year ROI, including financing costs, would be 98%=($2000-$500-$500-$255)/$755, while the annualized ROI would be 9.8%.

Finding ROI Tools on Investing.com

The Profit Calculator at Investing.com is a convenient tool for calculating the profits of futures and Forex trades. The search box on the page allows the user to select the market desired, and a calculation of the profit or loss is performed by clicking on the Calculate button.

Current exchange rates and futures contract specifications are automatically used for the calculations. Also, the main page of every security on the website includes charts and historical data that can be used to calculate the ROI on any investment, e.g., Amazon (NASDAQ:AMZN).