What is Return on Investment (ROI)?
Return on Investment (ROI) is a popular profitability metric used to evaluate how well an investment has performed. It is expressed as a percentage and represents the amount of money gained or lost relative to the amount of money invested.
How to Calculate ROI
The basic ROI formula is straightforward:
ROI = [(Amount Returned - Amount Invested) / Amount Invested] × 100%
Annualized ROI
While basic ROI tells you the total return over the life of an investment, it doesn't account for how long that investment was held. Annualized ROI standardizes the return by showing what the average yearly gain was. This makes it much easier to compare a 50% return over 5 years against a 20% return over 1 year.
The annualized ROI formula is:
Annualized ROI = [(1 + ROI)1/n - 1] × 100%
Where n is the number of years the investment was held.
Why ROI Matters
Investors use ROI to judge whether a particular investment is worth the risk. It's also a powerful tool for businesses to decide which projects to fund. A higher ROI generally indicates a more desirable investment, though it should always be considered alongside other factors like risk and liquidity.