How to Calculate Returns on Investments

When you invest in something, be it stocks, a business, or anything else, you of course want to make money, or have a return on your investment. To know if your investment has been successful, you will need to rely on the financial metric known as ROI, or Return on Investment. Excellent to use whether you are examining the return on only one investment or multiple investments, the ROI is a ratio that compares your investment's gain or loss to the cost of the investment itself. If you want to know how to calculate an ROI, its advantages and disadvantages, and much more, here is all you need to know.

Calculating Your ROI

To calculate your ROI, you begin by subtracting your investment's beginning value from its final value, which equals your net return. After doing this, your next step is to divide your net return by the cost of your investment, then multiply this number by 100. While it may sound a bit complicated, it's actually quite easy, and is in fact easy to understand, so much so that the ROI is used worldwide as the standardized measure of an investment's profitability.

An ROI Alternative

Along with calculating the ROI in the manner described above, there is an alternative method you can use to gauge your investment's profitability. To do so, you can subtract your investment's initial value from its final value, then divide the result by the investment's cost and multiply by 100. Since either method will yield you the same result, it matters little which one you prefer.

How to Interpret Your ROI

Now that you know how to calculate your ROI, it's equally important that you know how to interpret the results. In many cases, it's often a good idea to sit down with your CPA when doing this, since they may be able to point out things good or bad that you might be missing.

If you calculate your ROI and wind up with a positive number, your net returns will be referred to as being "in the black," meaning you made money because your total return was more than your total cost. However, if your ROI calculations result in a negative figure, you are now "in the red," meaning you lost money since your total costs were more than your total returns.

When you want the most accuracy when calculating an ROI, an annualized ROI works best, since this will let you and your CPA examine the total costs and total returns of multiple investments at once.

Leverage in Combination with ROI

In many cases when ROI is being calculated, individuals will also bring leverage into the equation, which can be both good and bad. On the one hand, if an investment was profitable, leverage will make the ROI look even better. However, if losses were sustained, leverage magnifies these as well, making an already bad situation look much worse. Almost always, ROI will look better if leverage is not included in the equation.

Unequal Cash Flows

If you are considering investing in a business that has an unequal cash flow, the ROI calculation will become more complicated, since the ROI is likely to fluctuate each year. When doing this type of calculation, you will need to use the internal rate of return (IRR) found in a typical spreadsheet.

In many cases where unequal cash flows exist, the ROI will be greater sooner rather than later, since larger cash inflows typically occur early on with most businesses. By having a positive impact on the IRR, this leads to a positive impact on the ROI.

ROI Advantages

The biggest advantage of an ROI is its simplicity in being able to be understood by investors. Since the basic ROI calculation is relatively simple, it is a metric that can be quickly determined and used to make business decisions on many levels. Whether it is an individual investor or a company that is considering making a multi-million dollar investment, the ROI is what is used when deciding whether to go all-in or look elsewhere.

ROI Disadvantages

While the ROI does have numerous advantages, it also comes with four disadvantages that you should talk over with your CPA so that you understand them.

First, an ROI will most often not take into account how long investments are held, which may create problems if you are wanting to compare various types of investment alternatives. However, if you use an annualized ROI, this problem can usually be solved.

Second, an ROI does not adjust for the risk associated with an investment. As you know, investment returns are directly linked to an investment's risk factor. Generally, if you wish to get extremely high returns on an investment, you are putting yourself at much greater risk of significant financial losses. Thus, as an investor, it is not recommended that you only use the ROI to determine if an investment is best for you. Instead, talk to your CPA and let them combine the ROI with other elements to help you make the best decision.

Third, ROI figures are sometimes exaggerated, especially if all costs are not included in its calculation. This often happens with real estate investments, since such expenses as maintenance costs, insurance, mortgage interest, and property taxes may be excluded by choice or by mistake.

Finally, an ROI only looks at the financial gains associated with an investment. In today's world, more and more investors are also concerned about the social or environmental impact associated with their investments. To calculate this, a new metric known as the Social Return on Investment (SROI) is being used to address these concerns.

ROI and Your CPA

While an ROI is simple in some ways, it does still leave the door open for many questions about how profitable your investments really are, how they are impacting the world around you, and so on. If you want your questions answered by a financial professional who can give you peace of mind, speak to your CPA.