How To Calculate Return On Investment
ROI is a simple term that is often used in the investing business. Investing is essentially all about ROI, if you have a positive ROI, your making money, if you have a negative ROI, your losing money and need to make some changes. In this article, we will teach you exactly how to calculate return on investment.
Formula For ROI
ROI has a pretty simple formula, it is simply your gains minus your cost, divided by your cost. Here is an example:
Your friend is starting an online website and needs your help. He offers a $20 000 opportunity to own half of the company. His business is quite successful, but for unknown reasons you request a buy out when the company is worth $200 000. Your friend agrees to the buyout and will pay you $100 000. Lets crunch some numbers
Cost = 20 000
Gains = 100 000 – 20 000
ROI = (100 000- 20 000)/ 20 000
ROI = 4, or 400%
When calculating ROIs, you simply multiply the number by 100 to get your ROI in a percentage.
0.15 x 100 = 15%
Don’t Be Tricked By Dollar Numbers
When looking at the ROI of an investment, we must not let dollar values skew our interpretation of the investment. If Bob made 500 dollars on an investment and Jane made 100, its easy to look at Bob’s investment and say it was the better of the two. Lets crunch some numbers again
Cost = 50 000
Gains = 50 500 – 50 000
ROI = (50 500 – 50 000) / 50 000
ROI = 0.01, or 1%
Cost = 1000
Gains = 1100- 1000
ROI = (1100 – 1000) / 1000
ROI = 0.1, or 10%
Although Jane made less money, she took significantly less risk in making that money and her investment would deem to be more profitable.
Factor in Time
When we look at calculating the ROI of an investment, it is also important to look at the time it takes to make that money. If Bob can make a 1 percent return monthly, while Jane can only make a 10 percent return yearly, which would be the better investment? If you look over both investments a year from now, although Jane’s ROI is bigger, Bob’s investment at years end actually has a higher ROI(12 percent compared to 10). This of course is a very simple time calculation, assuming both investments are guaranteed to pay off, which is usually never the case, but we will get into time calculations at a later date.
I hope you grasped the basics concepts of how to calculate return on investment in this article, and now have an idea of what ROI means. Remember, it’s not always dollars made. There are many factors, such as risk, lack of capital, and time that can make a smaller dollar return, yet a higher ROI the better option in the end.