Tag: Real Return On Investment

  • ROI or Return On Investment – The Efficiency Of Investment

    ROI or Return On Investment – The Efficiency Of Investment

    ROI or Return On Investment
    ROI is a useful method to compare different investment opportunities, but it has limits

    ROI or Return on Investment estimates the gain or loss created on an investment related to the amount of money invested. Investors use ROI to compare the performance of different investments or to compare a company’s profitabilities. In essence, the Return on Investment measures the gain or loss of some investment relative to the capital invested. 

    The main goal of investing is profit, so it’s essential to seek investments that give the biggest potential return. ROI or Return on investment is the ratio of profitability that measures how big return will be on some investment relative to the costs. Commonly, you can see ROI as a percentage. This measure is very important when you want to evaluate an investment.

    Also, ROI is a valuable tool when you want to compare several investment opportunities. 

    For example, you have some dilemma in which company to invest in because you saw several interesting options. And it seems that all of them are good. What are you going to do? Of course, you are going to estimate the efficiency of each company particularly to reveal which one is able to generate more profits.

    How to calculate ROI or Return on Investment?

    To calculate ROI just divide the net return on investment by the cost of investment and multiply the result by 100 since ROI is expressed in percentages.

    The formula looks like this:

    ROI = (Net Return / Cost of Investment) x 100

    For example, you invested $10.000 in some stock a year ago. Now you sold it for $15.000. Let’s calculate the return on your investment.

    $15.000 – $10.000 = $5.000
    Your net return is $5.000. Let’s go further by following the formula. 

    ROI = ($5.000/$10.000) x 100 = 50%
    And you find ROI on your investment is 50%. The calculation is quite simple.
    To calculate ROI you can use this formula too:

    ROI = ((Final Value of Investment – Initial Value of Investment)/Cost of Investment)) x 100%

    Calculate ROI for different investments

    The basic ROI formula reveals how much an investment generated overall. But, if you want to compare ROI from several investments, you will need to take into consideration the amount of time needed for some investment do give you return.

    For example, let’s say you want to compare the ROI from two separate investments. Let’s do this using our previous example. The capital invested is $10.000. One year later you sold the shares for $15.000 and gained $5.000, so the ROI is 50%.

    But two years prior to this purchasing you bought some stake of shares of the other company and you invested, let’s say, the same amount of $10.000. After 3 years of holding it, you sold these shares for $16.000.

    Let’s calculate the ROI for this investment.

    ($6.000 / $10.000) x 100% = 60%

    ROI is 60%. Great! 

    Wait for a moment. It just seems that this second investment yielded a higher ROI. You had to hold this investment 3 years to generate a return of 60%. In other words, time matters. 

    The first investment generated 50% after one year, the second returned more but after 3 years. It generated 60% which means the annual return of just 20%. When you compare these two investments and their annual yields it’s clear that you made a better investment decision in the first example. To put this simply, even if you have a better overall return on some investment think about the amount of time you needed to reach it. The annual ROI is what will tell you about how good your investment is. Do it for each investment in your portfolio and you’ll figure out the winners.

    The other methods to calculate the return

    There are more precise methods to calculate return on investment. ROI isn’t the only one and has its limits. 

    To be honest, calculating ROI is an excellent way to compare investment chances. But one of the limitations of ROI is the lack of risk estimation. ROI formula doesn’t factor it into consideration. The risk estimation is very important particularly when you need to calculate actual returns. ROI is good to show you a potential return on your investment. But will it tell you how much you can lose? Not necessarily. 

    You must know that higher returns are in tight connection with more risk. The Higher returns, the more risk involved. This is particularly true for stocks. They have higher returns than bonds, for example, but at the same time, they are riskier. 

    Almost the same is for companies. When the company has a lower credit rating, it will offer a higher interest rate on bonds to balance the investors’ risk. 

    For example, you purchased the bonds from a company described above. It offered you much higher returns on its bonds and you might think it is a better opportunity than some company with good credit rating. And you made a calculation and saw ROI of, let’s say, 60% after one year. So, let’s see why it wasn’t a smart decision. What will you do if that company fails to pay interest rates? Well, you’ll end up literally without any returns. 

    Can you see where the point is? ROI is great but it measures only the potential return on investment, not actual. For proper decision, you will need a Real Rate of Return that takes into account inflation, taxes, and other factors. Also, the Net Present Value (NPV) is more suitable for investors like to estimate returns in the far future.

    This metric is helpful

    As most important, it is a simple metric, and easy to calculate and understand. You cannot misunderstand it. Moreover, it is a general measure of profitability applied everywhere all over the world. When you see that some investment has an ROI of 30% that is the same in the US or Europe or Africa. Thanks to its simplicity ROI is good enough for estimation the efficiency of a single investment or to compare the returns from several different investments.

    What is a good ROI?

    Investment returns must beat inflation, taxes, and fees because no one would like to hold an average investment. We all need excellent investments. That’s the whole wisdom, to earn a higher rate of return on investments. 

    A good ROI depends on the investment. The truth is that you have to keep expectations rational. For example, if you are expecting to gain 20% from blue-chips over the next 10 years, we have to say your expectations are pretty much unrealistic. It isn’t going to happen. Whoever promises you that, plays on your inexperience. For instance, the stock market’s average annual return is about 10%, for more aggressive investors it was about 15% per year. And it was almost the same for the last 100 years. Take it or leave it. Whoever promises you a moon is lying or trying to fraud you. 

    Bottom line

    ROI or Return on Investment calculation isn’t an accurate metric but it is a good way to reach the approximate figures. You can always expect some deviation or error in ROI calculation.
    ROI is rated as the single most significant measure of the efficiency of an investment. A better ROI means that investment has satisfying results. When you want to compare the ROI of different investments it is important to compare the companies from the same or similar sectors.
    This metric is very connected to what happened in the recent past. You have to follow a simple rule of thumb: the lower the recent returns, the higher the future returns. And vice versa.

  • Real Return On Investment

    Real Return On Investment

    Return On Investment

    Return on Investment or ROI, measures the profitability of an investment, for every amount you put in, what profit can you expect.

    Return on investment is a measure practiced to estimate the efficiency of your investment. Also, you can use it to compare the efficiency of different investments. ROI seeks to measure the volume of return on investment in comparison to the costs. So, to calculate ROI, you have to divide the return of your investment by the cost. The result will be displayed in a percentage or a ratio.

    How to Calculate Return On Investment

    ROI formula is:

    ROI = (Current value of investment – the cost of investment)/cost of investment

    Compounding interest sounds like alchemy for many new investors, but ROI is true magic. Particularly when your money rises each year.
    Let’s say you invest $2,000 at 5% interest. You’ll have $3,500 in interest after 15 years. Your initial capital would be grown by $1,500 of interest. But if you invest at a 5% annual compound interest, you will have about $4,158.

    But where is the magic?
    The magic comes now. What if you can earn a higher rate of return?

    What if you invest at 8% or 10%? This can be really important because it is your money and you would like to watch it grow.

    True magic lies in math.

    Let’s say you have an investment goal and also, you know how long you want to hold your investment. For example, you would like to sell some of your stocks after 2 years. Assume you invested $2,000 in the stock. And you did that. You sold your stock for, let’s say, $3,000. Great! You made $1,000 in profit. That is 50% of return which is amazing if you want to calculate it quick and dirty,  and incorrectly. But, you need to factor in your liabilities and annual inflation rate to calculate the real return on investment. Okay, you have to pay a capital gain taxes, for example, it is $150, so you ended at $2,850 which is still good. Yes, your return will not be 50% it is 42.5% after you pay capital gain taxes. Oh, wait! Where is the inflation? Yes, you have to calculate the inflation over those two years. Let’s say the inflation rate is 2.5%.

    $2,850/(1.025×1.025) = $2,713

    Your real value return will be 35.65%.  It is less than 50% of return what you may be expected but it’s still good.
    It was a bit complicated but correct, which is the most important. And it is for two years. Do your own math for longer periods.

    Several things you have to keep in mind.

    A good return on stocks has to surpass inflation, taxes, and fees. Only in that way, you’ll be able to build your wealth.
    Use ROI to compare investments even if they’re not related. It isn’t the same if you are buying blue-chip stock or small-cap. In short, everything is different. But, if you compare only ROI may provide you a clear insight into where you want to direct.

    ROI can be used in combination with the rate of return, which takes into account the time frame, which we did. You can use a net present value or NPV, which we did to calculate the real rate of return.
    The usual return on investment for the majority of investors is about 2-3%. It isn’t great. But if you keep your money in a bank account you will have a negative return, after you factor and pay all taxes and inflation. 

    A  good return on investment is 10-12% per year

    You can beat the market. That is everyone’s goal, right?
    But if you expect to earn 15% or 20% – it’s not going to happen. Or it will happen very rare. Don’t believe in false promises, they are counting on your lack of experience. If you build your financial security on bad premises you will end in a risky field. You may lose all your capital. If you have a more conservative approach to investments you will have a less stressful experience. Investing should give you certainty.

    Bottom line

    ROI is a popular measure due to its simplicity and versatility. Typically, use ROI as a simple measure of your investment’s profitability. Use the ROI on a stock investment. The calculation isn’t difficult. It is easy to understand. If your investment’s ROI is net positive, it is good. Avoid negative ROI, it is a signal of a net loss.