Return on investment (ROI) is a financial ratio used to understand the profitability of an investment and suitable for comparing apple-to-apples investment options. ROI is generally defined as the ratio of net profit over the total cost of the investment.
The formula for ROI is straightforward and Return on investment (ROI) is calculated by dividing the profit earned on an investment by the cost of investment and expressed as a percentage.
Formula
ROI = (Present Value – Cost of Investment / Cost of Investment) x 100
Example 1
If an investment of $250,000 with no fees or costs fetches net profits of $315,000 after one year from the date of initial investment. Then
ROI = (315,000 – 250,000) /250,000 * 100
Your return on investment would be 26% for one year.
Example 2
Mr. A purchased a property for $900,000. After one year he sold it for $1,100,000.
ROI = (1,100,000 – 900,000) / (900,000) = 22.22%
Your return on investment would be 22.22% for one year.
Annualized ROI
The simple rate of return calculates the total percentage gain or loss on an investment without considering the period but on the other hand, Annualized ROI is a way to express the return on an investment over a year, considering the effects of compounding.
The calculation for annualized ROI adds in one of the key elements that’s missing from the standard return on investment equation which is time factor.
When we want to calculate annualized ROI we use below equation:
Annualized ROI percentage = [((1+ROI) x 1/n) − 1] × 100
In this case, “n” is equal to the number of years an investment is held. For holding periods shorter than a year, convert “n” to a fraction of a year using a decimal.
Or we can also use formula as below:
Annualized Rate of Return Formula = (Ending Value / Beginning Value)1/n – 1
Here,
- Ending Value is the value of investment at the end of the period
- Beginning Value is the value of investment at the beginning of the period
- n stands for the number of years
Example 3
Mr A purchased a property for $900,000. After 4 years he sold it for $1,100,000.
Annualized ROI percentage =
Here I have use same example#2 with different years. Example 2 investment was for 1 year so return was 22.22% but on same data with 4 years then Annualized ROI percentage is 5.14%.
ROI vs. IRR
Two of the most used financial metrics to evaluate investments are the internal rate of return (IRR) and return on investment (ROI). ROI is a simple and straightforward method to measure profitability on any investment while IRR is a complex but offers a more comprehensive perspective by considering the time value of money and other risk factors.
Please review: https://accountingblogger.com/internal-rate-of-return-irr/
The Bottom Line
ROI calculations are simple and helps an investor to decide whether to take or skip an investment opportunity. Using ROI can be a good place to start in evaluating an investment, but don’t stop there. Annualized rate of return (ARR) has many added advantages as compared to ROI such as it is more accurate measure of return specially when investment is long term. Investment duration is a vital factor while calculating ROI. Other factors are industry norms, goals or targets for investment and risks associated with any investment.
Humayun Atif | CMA, CPA, CA (FIN), MS-IT, CA Articles from Big 4, Certified Forensic Accountant (USA), Six Sigma & Oracle Certified.
Atif is passionate about Business, Tech, and the written word. He is the author of the book ‘IFRS Made Easy’. He is a Tax and IFRS coach and the founder of accountingblogger.com