What is Return on Investment?

Return on investment measures the ability of an investment to generate income. The ratio is used to compare alternative investment choices, as well as to determine if an existing investment represents an efficient use of resources. This is one of the most popular investor measurements, given the easy availability of the required information and the simplicity of the formula.

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How to Calculate the Return on Investment

The calculation of the return on investment is a two-step process, which is as follows:

Subtract the cost of an investment from its current value (which could be its sale price)
Divide the result by the cost of the investment

Thus, the return on investment formula is:

(Current value of investment - Cost of investment) ÷ Cost of investment = Return on investment

A variation on the formula that applies more to corporate decision making is to divide net income by invested assets. The formula is:

Net after-tax income ÷ Total assets invested = Return on investment

How Return on Investment is Used

The measurement can be used for multiple types of decisions. For example, an investor can use it to either estimate the future return on a prospective stock purchase, or to tally up the actual return at the time when the investor sells shares to a third party. As another option, a management team can use it to judge among differing uses to which an investment fund can be put. However, one should also consider the impact of an investment on the corporate bottleneck, which constrains the total profit that a business can generate. A third possibility is for a management team to use the return on investment as one of its criteria before authorizing expenditures on a variety of programs, such as employee training or a marketing campaign.

Problems with the Return on Investment

There are several issues associated with the return on investment concept, which are as follows:

No risk component. The main drawback when using the return on investment is that it does not contain a risk component. That is, there is no indication of the probability that a return will actually be generated in the expected amount. The implication is that an investor might be attracted to an investment with a high ROI, only to lose the invested funds due to a project failure, since he did not consider the risks associated with the project.
No strategic analysis. The return on investment concept does not account for the strategic direction of a business. In many cases, management is willing to accept a lower return on investment in exchange for gaining new products, capabilities, and market share in its desired markets - which tend to improve the return on investment over the long term.