Return of Investment is a ratio between the net gain and net cost of an investment. This financial metric is commonly used to measure the probability of earning a return from an investment. Since the main advantage of this metric is simplicity. ROI is usable in evaluating stocks, business ventures, to real estate. Moreover, the result of this metric is in percentage, which helps interpretation effortlessly.
Return On Investment (ROI) Formula: (Gain from Investment – Cost of Investment)/ Cost of Investment
This formula does not take any risks associated with the investment into consideration. Therefore, it can be assumed that it is one of the biggest limitations of Return on Investment.
Let’s suppose that an investor wants to buy the property in Chicago for $400,000. After three years, he will sell the property for $750,000. Taking the above formula into consideration, we will calculate the return on his investment on this property.
ROI= ($750,000 – $400,000) / ($400,000) = 87.5%
The same formula is also useable to calculate the cost of investment if we know the ROI. For instance, if the investor wanted an ROI of 50%, and he knew his initial cost of investment, he could take out the gain from the initial investment to realize his desired return on investment.
Annualized return on Investment varies from basic Return on Investment as it takes into account the Investment Time/ Holding Period. Furthermore, if we compare the results of these two calculations, the annualized ROI is more useful than the basic ROI figure. While the time factor is the key for annualized ROI, it still does not include the investment risks and other situations.