Explanation of Return on Investment
Return on investment is the ratio between the gain or loss of an investment compared to the amount of money invested. Thus, the ratio is subject to substantial interpretation depending on how it is employed. While the return on investment is easy to calculate, investors should be wary of its calculation. It is a simple test of profitability.
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Computing Return on Investment
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The first step in computing the return on investment, or ROI, is to decide the time period being measured. The next step is to compute the total value of the investment employed to produce a return. This is the denominator. Compute the net amount of gain (or loss). This is the numerator. Divide the investment profit (or loss) by the invested amount. Multiply by 100 to express as a percentage. The result is the return on investment.
Time Considerations
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The chosen time frame is a crucial element of computing ROI. For example, computing typical stock market returns from the beginning or end of a recession produces very different results. Choose appropriate time periods. Return on investment is predicated on a careful analysis of when outlays for a project occur, not when the outlays produce positive investment results.
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Investment Considerations
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Measurement of the total invested amount must be carefully considered. Outlays made regularly over several years should reflect the time value of the money or the weighted average term of the payments. The investment amount is not the beginning or end of the payment stream. It is the average of all investment weighted as a single payment.
Leverage Effects on ROI
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Consider how leveraged borrowings should be measured. A 10 percent return on investment becomes a 20 percent ROI if half the investment funds are borrowed, and a 30 percent ROI if two-thirds of the investment funds are borrowed. ROI does not account for risk. Thus, there is the necessity for a risk measurement to compare any like investments that employ leverage.
Cost of Capital
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Cost of capital combines the cost of debt, dividends on investment and alternative uses of capital that a company might invest. It is used to measure what the true cost of new investment is to a company. ROI is important because for the parent company to be successful the ROI of any company-owned business or project must exceed the company's own cost of capital.
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