Return on Investment (ROI) 

In finance, Return on Investment, usually abbreviated as ROI, is a common, widespread metric used to evaluate the forecasted profitability on different investments. 

The metric can be applied to anything from stocks and real estate, to a sheep farm…or even to an ice cream business; anything that has a cost with a potential gain can have an ROI assigned to it. 

While much more intricate formulas exist to help calculate the rate of return on investments accurately, ROI is still widely used due to its simplicity and broad usage as a quick-and-dirty method. 

ROI may be confused with ROR, or rate of return. Sometimes, they can be used interchangeably, but there is a big difference: ROR can denote a period of time, often annually, while ROI doesn't.

The basic formula for ROI is:

As a most basic example, let’s say you want to calculate the ROI on your ice cream business. From the beginning until the present, you invested a total of $200,000 into the project, and your total profits to date sum up to $300,000 (of course, you work with your CPA to deduct as many ‘legal’ expenses as you can in order to reduce taxes!).

Your ROI on the ice cream business is 50%. 

Conversely, the formula can be used to compute either gain from or cost of investment, given a desired ROI. If you wanted an ROI of 50% and knew your initial cost of investment was $200,000, $300,000 is the gain you must make from the initial investment to realize your desired ROI.

Difficulty in Usage

It is true that ROI as a metric can be utilized to gauge the profitability of almost anything. However, its universal applicability is also the reason why it tends to be difficult to use properly. While the ROI formula itself may be simple, the real problem comes from people not understanding how to arrive at the correct definition for 'cost' and/or 'gain', or the variability involved. For instance, for a potential business, investor A might calculate the ROI involving costs of goods sold and overhead expenses, while investor B might only use gross profit. Also, does an ROI calculation involve every cash flow in the middle other than the first and the last? Different investors use ROI differently.

However, the biggest nuance with ROI is that there is no timeframe involved. Take, for instance, an investor with an investment decision between a diamond with an ROI of 1,000% or a piece of land with an ROI of 50%. Right off the bat, the diamond seems like the no-brainer, but is it true if the ROI is calculated over 50 years for the diamond as opposed to the land's ROI calculated over several months? This is why ROI does its job well as a base for evaluating investments, but it is essential to supplement it further with other, more accurate measures.

Feel free to contact me if you’d like to work through an ROI calculation with your specific costs and returns.

Rob