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What is Return of Investment (ROI)?
Return on Investment is a performance measure used by people to determine the profitability of an investment or compare performance of different investments over a given time period. As evident, ROI is a value metric used to calculate an investment's success or to compare the productivity of different investments in delivering a return on Investment. To evaluate ROI, you can simply divide the end of period value of your investment with the initial cost of the investment.
What is the Return on Investment Formula?
Return on Investment aims to measure the level of a single investment with returns explicitly, relative to its cost. In other words, the ROI formula comprises the splitting of an investment’s profits by its costs. The Return on Investment formula is illustrated below:
ROI = (Current Value of Investment – Cost of Investment) / Cost of Investment
Here, the "Current Value of Investment” means the proceeds gained from the sale of the Investment of interest. Since the return on investment is calculated as a percentage, the ROI can be easily compared with other investments of returns, allowing one to compare a range of different investment options available.
You can also use an ROI calculator available online to estimate the Return on Investment for an instrument.
How to Calculate the Return on Investment?
In case you are unsure about how to calculate Return on Investment, it is easier than you think. To calculate Return on Investment or ROI of any investment needs only two numbers: the investment cost, and the current value of that instrument & use the following formula to calculate ROI easily.
ROI = (Current Value of Investment – Cost of Investment) / Cost of Investment
But within each, there are inputs. It is where the easy gets complicated for others. Yet it doesn’t have to be?
Also Read: What is Investment?
Below are 8 remarkably easy measures for calculating the Return on Investment (ROI):
- Start with a Baseline
- Decide if the ROI is Revenue or Profit
- Determine the Time Frame
- Decide the Inputs for the Returns
- Identify the Investments
- Calculate the ROI of Investment with Returns
- Guide with KPIs
- Align with Desired Goals
Let’s understand all these measures for calculating ROI in detail below:
Step 1: Start with a Baseline
To calculate the Return on Investment from a new undertaking, you must first consider precedence by setting a benchmark. There are only three reference examples in this context.
The company in Scenario 1 is only starting, and there is no precedent. A blank slate is in there.
In Scenario 2, the new initiative aims to improve only one aspect of the activities of an investment with returns. In this case, the baseline is the return from the previous cycle in this area.
In scenario 3, the Investment requires a transition or restructuring, which is likely to affect many areas.
Step 2: Decide if the Return on Investment is Revenue or Profit
Be explicit from the start how you will calculate the Return on Investment for an instrument. Is the ROI profit or revenue? For some instances, this differentiation is the most desirable factor. But sometimes, this segregation is harder to understand and to control.
Step 3: Determine the Time Frame
Before you can define the Return on Investment, you must know how long it is going to take. In most instances, the time frame for ROI is between 1-2 years.
Step 4: Decide the Inputs for the Returns
Return on Investment is a projection or estimate of what will happen by the end of the time frame. Use actual statistics, not metrics or percentages, because you want normative outcomes. Trust in the data ensures the Return on Investment is accurate of the given instrument.
Step 5: Identify the Investments
This is self-evident in some situations. Not always, however. Let us say a significant infrastructure project is taking place, which will take a couple of years, but the Return on Investment period is one year. An investment with a Return on Investment is focused on the cash balance and the spending in that year. Hence, you should choose the Investment with a substantial ROI after a thorough online and offline research.
Also Read: How to Choose the Best Investment Plan?
Step 6: Calculate the ROI of Investment with Returns
The Return on Investment formula is simple (as illustrated above). To ease the process of calculating the Return on Investment, you can use an online ROI calculator to estimate whether the investment opportunity will provide the desired Return on Investment.
Step 7: Guide with KPIs
Return on Investment is a prediction of a possible result, and a primary indicator scorecard is built to keep ROI of any investment with returns on target. These are measures of core success or KPIs. A Key Success Metric is a tangible attribute that indicates how successfully a company is meeting its business goals.
Step 8: Align with Desired Goals
Return on Investment is key to assessing how realistic is the objective and profit when it comes to the investment plan with returns.
Return on Investment is a prediction of a possible result, and a primary indicator scorecard is built to keep ROI of any investment with returns on target. These are measures of core success or KPIs. A Key Success Metric is a tangible attribute that indicates how successfully a company is meeting its business goals.
Step 8: Align with Desired Goals
Return on Investment is key to assessing how realistic is the objective and profit when it comes to the investment plan with returns.
What is the Thumb Rule of Calculating the Return on Investment?
There are specific thumb rules which promote the implementation of the time in Return on Investment [1]. These simple rules assume that the average return rate remains constant, and the Return on Investment is compounded once a year. Out of all the rules, Rule of 72 is the most important one.
What is Rule of 72 for calculating the Return of Investment?
The Thumb rule of 72 is an easy way to estimate how long it would take for an investment to double at a given annual interest rate. The required period of Investment is calculated by dividing 72 by the ROI (Return of Investment). Like, for example, if the Return on Investment is 12, then it will take (72/12), which is 6 years to double the Investment
Along with the thumb rule of 72, here are the other important rules that are followed when calculating the Return on Investment.
Rule of 114: It shows how long the money will take to triple. To compute this, divide 114 by the Return on Investment. It will take around 9.5 (114/12) years for your money to grow three times at the given ROI.
Rule of 144: It calculates how long it will take to grow your money four times. In the example considered, the time taken to quadruple your money is around 12 (144/12) years.
While these figures are promising, they are by no means wholly accurate and reliable.
A good understanding of Return on Investment (ROI) is a requirement for making wise investments with returns. Therefore, one must measure and compare the Return on Investment of different investment options under consideration
Rule of 144: It calculates how long it will take to grow your money four times. In the example considered, the time taken to quadruple your money is around 12 (144/12) years.
While these figures are promising, they are by no means wholly accurate and reliable.
A good understanding of Return on Investment (ROI) is a requirement for making wise investments with returns. Therefore, one must measure and compare the Return on Investment of different investment options under consideration
What is an Ideal Rate of Return on Investments?
The first thing you should do is take out inflation regarding any investment that promises to provide a substantial Return on Investment. The reality is that investors are interested in increasing their Real Rate of Return on their Investment when they put their money into an instrument.
Because of its versatility, Return on Investment or ROI is one of the most-used productivity measures. On the other side, one of the downsides of the Return on Investment formula is that it can be misleading to show different outcomes for different users. Thus, it is essential that you use the same inputs when considering Return on Investment to compare different investment opportunities.
It is also essential to consider that the simple estimation of Return on Investment does not take time into account. Earning a return of 15% for a year is more attractive than earning 15% cumulative for 2 years when we talk about instruments with a Return on Investment. One should look at annual ROI numbers while comparing multiple investment options.
Will you always get a fixed return on a bond?
If you hold these bonds till maturity, then you will get a fixed return on your invested money. But if you sell the bond prematurely, its price will depend on market conditions prevailing at that time. If your sale price is higher than your purchase price, your return will also be higher accordingly and vice versa.
However, the bond market is less liquid than the equity market, meaning you may not get the best price if you want to sell it before maturity.
ROI Affects Your Choice of Investment with Returns
In recent times, many investors and enterprises are looking at a new way of calculating Return on Investment – it is called Social Return on Investment or SROI. Along with capital and profit, this SROI also considers socio-environmental factors. This ensures even more accuracy as they use additional financial value.
One such Investment is Unit Linked Insurance Plans or ULIPS. ULIPs are among the top-ranked financial products offering a substantial Return on Investment over the investment period. Moreover, ULIPs are one of the investment opportunities that provide a significant Return on Investment while providing additional protection of life cover to the policyholders. ULIPs invest a portion of the amount invested into equity shares, debt instruments, and bonds, while the remaining amount is invested towards providing the life insurance cover.
Also Read: Benefits of ULIP Plans
Earlier, the lock-in period of a ULIP was 3 years. However, it has been increased from three years to five years to reflect the long-term protection function of this Investment with a substantial Return on Investment [2].
Sources:
[1]https://www.investopedia.com/ask/answers/what-is-the-rule-72/
[2]http://www.policyholder.gov.in/Unit_Linked_Products.aspx
ARN: Sep/Bg/28U
