What Is Return on Investment (ROI) and How to Calculate It?

ROI or Return on Investment is the most often used way to evaluate a potential profit on a given investment. Before deciding whether to undertake a specific project, corporate investors try to make some calculations that could help them predict the ROI and whether it is worthwhile to invest in the project when they get preliminary numbers or a percentage. 

While the ROI investment is one of the simplest ways to calculate your potential returns, investors use it far and wide. You can use the ROI calculation formula for just about any investment type: stocks, commodities, bonds, cryptocurrencies, real estate, or your upcoming start-up. ROI can also be useful for retail investors, including crypto investors who have above average expectations and want to predict their return for a specific amount of money invested in a particular cryptocurrency for a particular period of time.  

The most straightforward formula to calculate ROI

ROI = Net Income (benefit) / Cost of Investment (cost)

It is the most simple and widely used formula where you divide your income by the cost of your investment to arrive at the return on investment. 

You can imagine that your income is the total benefit you get at the end, and the cost of your investment is how much you pay (input) into the project (asset). And you have your ROI! 

An example with BTC/USD

You purchase BTC/USD worth $1,000 for the price of $30,000 on the 20th of July 2021. On the 15th of October the same year, the price of BTC reaches $60,000, and you close your position getting back $2,000.  

Let’s apply the investment gain formula for the example

ROI = (2,000 – 1,000) / (1,000) = 1 or 100%

The application of ROI formula

Not only ROI is easy to calculate, but it also helps investors to make up their minds whether to undertake a specific investment project or not. They can also check how a particular investment has fared and if it is prudent to continue it. If the ROI is positive, investors will likely continue with it, and if it is negative (the cost was greater than the return), they will probably quit it altogether. 

The simple formula can help investors sift the wheat from the chaff by separating underperforming investments from well-performing ones. Utilizing the method, investors can achieve a much greater level of optimization. 

The advantages of the ROI

The ROI formula stands out. First and foremost, it is easy to apply. Input two numbers: income and cost. A return is a relative term, which may mean different things to different people. There is no universally accepted definition for it.  

On the other hand, as the word is universally understood, there is no misunderstanding of what the return term refers to with most investors. 

The disadvantages of the ROI

Although the formula to calculate ROI is simple, it has disadvantages. Firstly, it does not include timing in the picture. While a high ROI may be an attractive number, it may not necessarily mean the investment is better than the one with the lower ROI. Why? Two assets can have the exact ROI of 100%, yet one is over in one year, while another is in three years. So, the absence of timing in the formula somewhat distorts the actual ROI that investors will get through the entire investment period. 

Secondly, the formula is easy to manipulate. An investment manager may decide to hide the total costs for the investments, including maintenance costs, property taxes, legal fees, etc. Thus, the real ROI will not be as high as presented, as some expenses are excluded from the calculation. 

Annualized ROI formula

You most likely see that excluded time factor in the most simple ROI formula does not distinguish between ROI of 50% achieved in three years and three weeks. No doubt, a three week ROI of 50% is not the same return as 50% for three years. Therefore, we need to adjust the formula accordingly. 

So, we had an example of BTC/USD given with regular formula. Let’s make calculations applying the same return and cost but annualized. 

Regular = ($2,000 – $1,000) / $1,000 = 100%

Annualized = [($2,000 / $1,000) ^ (1 / ((Oct 15 – Jul 20)/365) )] -1 = 1732.1%

While the crypto instruments are volatile, the annualized ROI may also deliver a somewhat distorted picture. However, investors heavily rely on regular and annualized ROI formula calculations in less volatile business ventures. 

Final thoughts

The regular ROI calculation formula is the easiest way to determine potential returns on your investment or evaluate how well your current investments are performing. To better understand how specific investments perform, you might want to adapt the ROI formula to give you annualized results. If the two formulas are not enough, an investor may refer to more advanced ones such as Internal Rate of Return (INN), Return on Equity (ROE), or Return on Assets (ROA).  

For information purposes only. Not investment or financial advice. Seek professional advice. Digital assets involve risk. Do your own research.

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