Calculating Return on investment
Return on Investment can be calculated for a number of things.
It is not just businesses but even investors who are able to use the formula
to identify whether an investment is going to result in benefits or not.
It also helps people make the most appropriate
choice from a range of options available.
Any investor requires Return of Investment to be
calculated in order to evaluate his investments.
Everything from the stock a person owns to a
collectible requires knowledge of the Return
on Investment to help the person make informed decisions regarding his investments.
The main formula for ROI is always the same,
but with other factors in play, the formula
may be modified to show the return on a particular investment more effectively.
It is important to consider these factors for an accurate
information regarding the return on an investment.
Simple Method
The basic formula:
There is nothing simpler than ROI when we discuss it as a formula.
To find out the returns on an investment you
begin by taking the gains on the investment
and the cost incurred and then divide it by the total cost of the investment.
This will give you the following formula:
ROI = (Gains-Cost) / Cost
To understand this better, consider the following example:
A boy buy 50 candies at a $1 each and then sells them for $1.25 each.
This means that his investment cost was $50 and the total gains was $62.5.
So the returns on the investment was:
ROI = (62.5-50) / 50
Which comes to 0.25 or 25%
Depending on the perspective of an investor,
this can be seen in different ways.
A popular way of looking at this is to picture that for every
dollar invested, the person gets a return of 25 cents.
When a person invests more in a certain investment option, it
results in a higher payout, but it does not affect the ROI.
The return on investment remains the same.
So if the boy buys 100 candies then his gains will be
$125 but the return on investment will still be 25%.
This will be the case provided no other factor changes.
Looking at the returns made from an investment in percentage helps identify which
investment will be more profitable when you have more than one option to consider.
When a person tells you about the gains on their investment, it is also necessary to
find out the cost which can then help you find out if that investment was good or not.
This is known as the simple method of ROI calculation because it designed in a way
that makes it easy for anyone to understand it and use it for their business.
Which means that a person does not have to be a financial analyst
or an economist to find out the Returns on an investment.
But the simple method does not take into account the change in the
dollar value which is usually considered as inflationary costs.
This is where many businesses find the Discounted Method to be more accurate.
The discounted method keeps in mind that the value of an
investment will change over a certain period of time.
It means that an investment of $10,000 may decrease in value after the
first year and it may become $9,500 in value by the end of the first year.
This changes the calculation and may lead to a
lower ROI but knowing that the company is keeping
the change in the value of dollar in mind, this
becomes a more accurate method of calculating ROI.
For a company however, things are not as
simple as the case of the boy buying sweets.
There are a number of costs which must be taken into account.
Many businesses calculate ROI to identify the potential of a business
and to find out if they should go ahead with an investment or not.
This is known as projected ROI.
When calculating the projected ROI for an investment,
here are the steps that the company should follow:
1. Determine the initial cash outlay
This happens to be the easy part.
The business is required to simply take all costs of investment and add them up.
The initial cash outlay covers all costs which get a project up and running.
It includes everything from equipment costs, installation costs,
cost of training people, startup costs and the cost of shipping.
Companies which are investing in a simple machine will find it
easier to identify the costs but when the cost of a project
that takes many months has to be calculated then
the initial cash outlay becomes more complex.
2. Forecast cash flows from the investment
This is a difficult area of calculation.
This requires the finance team to identify the net
cash the investment will be able to generate.
A lot of time is spent on understanding the
cash flows and making the right assumptions.
There are factors like working capital, taxes and other
non-cash expenses which may change over a period of time.
The company has to carefully make allowances for such variables and scrutinize the
overall cash flow to determine the net cash that may be generated by the investment.
3. Determining the minimum returns required by the business
The minimum rate of return for an investment
is also referred to as the hurdle rate.
The finance team of a company set the minimum rate of return.
Usually there are more than one minimum rates of return set by the company
which may happen when there are lots of risks involved in the investment.
The hurdle rate of a company is fixed by determining
the cost of the capital, the opportunity
cost of forgoing other investments and the risk
involved in taking up a particular investment.
4. Evaluating the investment
The last step of calculating the returns is using the ROI
calculation method to find out if a particular investment
will be able to offer returns which either meets
or exceeds the hurdle rate set by the company.
While the method for calculating ROI can be either
of the two methods for all the investments.
There are certain factors that must be taken into
consideration when various investments are being considered.
Some investment types which are very popular yet end up
being mishandled when it comes to ROI calculation are:
1. Real Estate
Real estate investments can lead to returns either through
rental income or through appreciation of the property.
For rental income, the income is added to the gains when they are realized.
But costs on real estate vary.
An investor has to take into account the initial purchase cost, the
taxes, property insurance and the costs of maintaining the property.
When investing in a property, a person has to look
beyond the sale and purchase price of the property.
There are other costs in the middle of it all which is often ignored in
an attempt to project a more luring picture to prospective investors.
This is especially the case in investment property
where insurance costs, taxes and maintenance
costs are often overlooked when trying to
calculate the return on real estate investment.
2. Stocks
Investors usually end up making the same mistakes
as real estate when looking at the ROI for stocks.
There are dividends which lead to gains and payments made when buying
or selling the stocks that have to be taken into consideration as well.
Omitting these details can lead to wrong calculation of the
return on investment for the stocks a person invests in.
Keeping other factors in mind is important every time
we look at the gains and the costs of an investment.
3. Collectibles
Collectibles end up selling at extremely high prices.
The ROI for any collectible can be sky high when
compared to the price at which it may have been bought.
But owners of such collectibles spend huge amounts of money for the
upkeep of the collectible or for ensuring adequate security around it.
All these things end up being ignored when the collectible’s ROI is being calculated.
When the costs of maintaining the collectible is taken into account,
then many of these collectibles will end up showing a lower ROI.
4. Leveraged Investments
ROI is not a suitable calculation for leveraged investments.
This is because these investments involve a lot of
risk and risk cannot be given any value in ROI.
This means that when a person ends up investing
$1 and gaining $3, then the ROI is 200% but
it does not take into account the risk that the
person had to take in making that investment.
If he lost and the value went down then he would end up losing a huge amount.
The risk-reward tradeoff is a completely different matter of discussion
where ROI may not be able to accurately help an investor identify
the best investment option since the risks to be considered
in the investment is not depicted in the ROI calculation.
ROI is simple and it is one of the most basic
calculations for making any type of investment.
It improves decision-making and provides any investor with
a figure that can supports the investment that they make.