Calculation of Return on Investment (ROI)

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The return on investment ratio is one of several financial ratios used to evaluate investment alternatives. An ROI analysis compares the magnitude and timing of cash inflows and cash outflows. The inflows compare favorably to the outflows in high-ROI projects, meaning the project costs are recovered faster. Businesses and investors can also use the ROI metric to evaluate the returns on their debt and equity investments.

Use

ROI is a core financial metric for investment decision making, such as building new plants, purchasing technology systems and planning business expansion. ROI is used in the nonprofit sector to justify public sector expenditures. Portfolio managers use ROI to assess the performance of existing investments and make trade-off decisions between competing investments.

Facts

The basic ROI calculation is the company's net profit or bottom line divided by the total debt and equity. For example, if a company's net profit is $1,000 and the total debt and equity investment is $10,000, then the ROI is 10 percent: 100 x ($1,000 / $10,000). For stock investors, the ROI calculation is the sum of the dividends received and the current market value minus the investment cost, and the result is expressed as a percentage of the investment cost. For example, if an investor pays $1,000 for Microsoft shares, receives $50 in dividends through the year and the shares are worth $1,100 at the end of the year, his return on investment is 15 percent: 100 x ($50 + $1,100 - $1,000) / $1,000.

Evaluating Investments

A business can compare the ROIs from two or more competing projects to determine which ones to fund and when. The cash flows are used to calculate the ROIs. For example, if one project has total cash inflows of $5,000 over the first three years and another has inflows of $3,000, and the outflows or costs for both projects are $2,500 over the same time period, then the ROI for the first project -- 100 percent: 100 x ($5,000 - $2,500) / $2,500 -- is greater than the second -- 20 percent: 100 x ($3,000 - $2,500) / $2,500. All else being equal, the first project represents the better investment because it has a higher ROI.

However, ROIs can change over the course of a project. For example, a bridge construction project might have a low or even negative ROI for the first few years while the bridge is being built, but the ROI will start to ramp up after it comes into service and tolls are collected.

Considerations: Social ROI

Public-sector projects do not generate cash inflows but result in socioeconomic benefits, such as employment programs for the disabled and retraining programs for older workers. According to Jed Emerson, former Harvard Business School senior lecturer and founder of consulting firm Blended Value Group, a social ROI analysis includes an examination of a program over a period of five to 10 years, an estimation of the investment costs to get the program up and running, and a calculation of the resulting cost savings and other benefits.

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