What Is Return on Investment?
How to Calculate Return on Investment
Return on investment (ROI) is a measurement of the profitability of an investment. Commonly expressed as a ratio or percentage, ROI provides a way to evaluate and compare assets or financial instruments.
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. Ultimately, ROI tells them how profitable their investments are, as well as allowing them to compare future investments for potential growth.
How Do You Calculate Return on Investment?
The most basic formula for calculating return on investment is:
However, when it comes to determining ROI on an investment, things get a bit more complicated. That's because ROI in investing typically involves trying to capture the value of money over time.
Depending on your requirements, several formulas will give you an idea of whether your investments are paying off. Some are more complex than others, but none are beyond the reach of the average investor who has a calculator.
1. 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. Typically, total return is 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, e.g. 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 is a simple calculation, but it reminds us that we need to include dividends (where appropriate) when figuring the return of a stock. Here is the formula:
For example, if you bought a stock for $7,543 and it is now worth $8,876, you have an unrealized gain of $1,333. Assuming that you received dividends during this time of $350, you could find your total return using the following steps:
- ($8,876 - $7,543) + $350 / $7,543
- $1,333 + $350 / $7,543
- $1,683 / $7,543
In this scenario, the total return would be 0.2231 or 22.31%.
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.
2. Simple Return
Simple return is similar to total return; however, 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 with cost basis taken into account.
How Do You Calculate Simple Return?
You can find your simple return by using the following formula:
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. Assuming your dividends amounted to $126, you could find out your simple return using the following steps:
- $3,988 + $126 ÷ $3,012 – 1
- $4,114 ÷ $3,012 – 1
- 1.36 – 1
In this scenario, 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. 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. Compound Annual Growth Rate
For investments held more than one year, you may want to look at this more sophisticated, 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, presuming that the investment has been compounding over the period.
How Do You Calculate Compound Annual Growth Rate?
To calculate the compound annual growth rate, use this formula:
- Divide the value of an investment at the end of the period by its value at the beginning of that period
- Take that result and raise it to the power of one
- Divide it by the period length (n)
- Then 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.
- Return on investment (ROI) is a measurement of the profitability of an asset or financial instrument.
- There are several different ways to calculate ROI, depending on your needs and requirements.
- Compound annual growth rate (CAGR) captures the value of an investment over time, but may underemphasize risk.