What Is Return on Investment?

Definition of Return on Investment

Man calculating Shutterstock_1903589221 Return on investment (ROI) measures how profitable an investment is. Many times, it is expressed as a ratio or percentage. ROI provides a way to evaluate and compare assets or financial instruments.

Key Takeaways

  • Return on investment (ROI) is a measurement of the profitability of an asset or financial instrument.
  • There are many different ways to calculate ROI, depending on your needs.
  • Compound annual growth rate (CAGR) captures the value of an investment over time, but it may underemphasize risk.

Definitions and Examples of Return on Investment

Investors calculate return on investment in order to determine profit or loss compared to the cost of their portfolio. ROI tells how profitable investments are. It also allows a comparison of future investments for potential growth.

How Do You Calculate Return on Investment?

The most basic formula for calculating return on investment is:

ROI = Net Profit/Investment Cost

When it comes to determining ROI on an investment, things get a bit more complicated. That’s because ROI in investing often involves trying to capture the value of money over time.

Depending on your needs, there are some formulas that can help give you an idea of whether your investments are paying off. Some are more complex than others, but none is beyond the reach of the average person with a calculator.

1. What Is Total Return?

Total return measures the profit earned from an investment over a set period of time. This metric includes dividends, making it a good way to measure the profitability of some stocks. Total return is often expressed as a percentage.

Definition of Total Return

Total return captures the combined value of an investment’s profits over a set period of time, such as a quarter or a year. These profits may include interest, dividends, and the changing value of the investment.

How Do You Calculate Total Return?

It’s simple math, but it reminds us that we need to include dividends (where appropriate) when finding the return of a stock. Here is the formula:

Total Return = (Value of Investment at End of Year

– Value of Investment at Beginning of Year) + Dividends

/ Value of Investment at Beginning of Year

For instance, if you bought a stock for $7,543, and it is now worth $8,876, you have an unrealized gain of $1,333. If you received dividends of $350 during this time, you could find your total return using these steps:

  1. ($8,876 – $7,543) + $350 / $7,543
  2. $1,333 + $350 / $7,543
  3. $1,683 / $7,543

In this case, the total return would be 0.2231 or 22.31%.

Note: You can use this calculation for any period, which is a weakness, since it doesn’t take into account the value of money over time.

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2. What Is Simple Return?

Simple return is similar to total return, but it is used to calculate your return on an investment after you have sold it.

Definition of Simple Return

Simple return calculates the value of your total profits on an investment, and it takes cost basis into account.

How Do You Calculate Simple Return?

You can find your simple return by using this formula:

Simple Return = (Net Proceeds + Dividends) / Cost Basis – 1

Let’s assume that you bought a stock for $3,000 and paid a $12 commission. Your cost basis would be $3,012. If you sell the stock for $4,000 (with another $12 commission), your net proceeds would be $3,988. If your dividends came out to $126, you could figure out your simple return using these steps:

  1. $3,988 + $126 ÷ $3,012 – 1
  2. $4,114 ÷ $3,012 – 1
  3. 1.36 – 1

In this case, the simple return would be 0.36 or 36%. Like the total return calculation, the simple return tells you nothing about how long the investment was held.

Tip: If you want to see after-tax returns, simply substitute net proceeds after taxes for the first variable, and use an after-tax dividend number.

3. What Is Compound Annual Growth Rate?

For investments held for more than one year, you may want to look at this more advanced, yet not much more complicated, calculation.

Definition of Compound Annual Growth Rate

The compound annual growth rate (CAGR) shows you the value of money in your investment over time. A 40% return over two years is great, but a 40% return over 10 years leaves much to be desired. Think of this calculation as the growth rate that takes you from the initial investment value to the ending investment value. This presumes that the investment has been compounding over the period.

How Do You Calculate Compound Annual Growth Rate?

To calculate the CAGR, use this formula:

CAGR = (Ending Value/Beginning Value) ¹/n – 1

  1. Divide the value of an investment at the end of the period by its value at the start of that period
  2. Take that result, and raise it to the power of one
  3. Divide it by the period length (n)
  4. Subtract one from that result

CAGR is useful when comparing investments over time, but it does smooth returns over the comparison period. This can underemphasize risk in volatile investments.

Source: The Balance Money