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Return on investment, or ROI, is the amount of money that you make as a percentage of your initial investment. ROI is used as a quick way to see how efficient an investment is as it provides the return based on how much money the investment cost you. A higher ROI means that the investment provided a higher return.
What You Should Know
- ROI is a measure of the amount of money you make on an investment as a percentage of what that investment cost you
- ROI does not account for how long you hold the investment, for the timings of returns, and for some of the costs involved in the investment
- Annualized ROI allows you to compare investments with different investment lengths
- ROI in real estate is mostly used to find the return that rental properties generate
- The Cap rate assumes the property is purchased using cash only, while ROI take into account the financial costs in the case that a mortgage is used to finance the purchase
- Stock ROI reflects the price appreciation/depreciation of a stock and the dividends distributed during a period
How to Calculate ROI
To calculate ROI, you would need to find out how much your investment has earned. There are two different ways to calculate ROI which lead to the same conclusion.
You calculate ROI by finding the net return of an investment. The net return of the investment is the total returns subtracted by the total costs of an investment. This net return will then be divided by the cost of the investment. To turn the fraction into a percentage, we multiply it by 100. The generated number will show the benefit we got from the investment as a portion of the investment’s cost.
The second method finds the return of the investment by using its final value and subtracting it by the initial value of the investment. This is then divided by the initial value of the investment and multiplied by 100 to turn it into a percentage form.
A business wants to calculate the return on investment for a new machine purchased. The machine cost the company $1,000. The machine generated $400 in income each year for 3 consecutive years. After the third year, the business sold the machine for $300. What is the machine’s ROI?
ROI= [((3 * $400) + $300) / $1,000] x 100% = 50%
An investor wants to calculate the return on investment for their stock investment. The stock cost the investor $100. After one year, the investor sold the stock for $90. The ROI calculation would be:
ROI = [($90 - $100) / $100] x 100% = -10%
Cap Rate vs. ROI
The capitalization rate of an investment, also known as the cap rate, is a similar measure of the profitability of an income-generating property. There is, however, one crucial difference. Unlike ROI, the Cap rate assumes the purchase of a property is made using cash only, which means that there are no financing costs such as mortgage and interest payments.
The idea behind both methods of calculation is that we need to find the difference between what we spent on an investment or what the investment cost us in the beginning and what the investment is returning or giving us now. This is the net return. On its own, the net return can only tell us if the investment has been profitable or not. In order to figure out how profitable the investment has been compared to its initial cost, we use ROI, which can also help us compare between 2 or more investment opportunities. To calculate ROI, the net return should be expressed as a percentage of the total cost of the investment. In other words, what the return is relative to the cost.
Because the net return on an investment can be positive or negative, ROI can be a positive or negative number as well. If the result of your ROI calculation is a positive number, then your investment made a positive return. If your ROI is negative, then your investment incurred a loss.
Why use ROI?
ROI is used instead of just looking at the investment’s return on its own so that the investment could be evaluated based on how efficient the investment was. If all you were told was that an investment made a return of $100, you would not be able to tell if this was a good investment or not.
Perhaps to make the return of $100 you only had to invest $1, which would have a very high ROI, or perhaps it would have required an investment of $1,000, which would have made it a poor investment choice. Rather than just looking at pure investment returns, knowing the ROI of an investment allows you to make a more informed decision of where to put your money.
Flaws of ROI
- Time of investments (holding period)
- Timing of returns
- Costs involved in the investment
What basic ROI does not take into account is time. Looking at ROI on its own would not give you much info to go on when comparing different investments. If you were told that an investment would have a ROI of 10% after 1 year, it might be a good investment choice. If there was an investment with a ROI of 10% after 100 years, then there might be other investment options that you should consider instead. While both of these investment options had the same ROI, the length of time of the investment matters.
Besides time, what ROI also misses is the timing of returns. ROI assumes that an investment’s return is steady and stays the same for the entire investment period. For example, if an investment had a ROI of 10% after 10 years, then that means that the investment consistently provided a return of 1% per year for 10 years. This misses the potential for fluctuations in returns for an investment within that 10 year period.
To account for the timing of returns, the internal rate of return (IRR) should be used for investments with more complicated cash flows. If the majority of an investment's return was generated in the early years of an investment, then the investment would have a higher ROI calculated using IRR than an investment that had steady returns throughout the same period.
Calculating ROI gets a bit more complex for returns of certain investment options. When looking at real estate, there are costs that would reduce the amount of your investment gain, such as property taxes, insurance, and maintenance. The cap rate, or capitalization rate, may be a simpler method to calculate the annual return of a real-estate investment that generates rental income when the property is bought using only cash.
What is Annualized Return on Investment?
Annualized return on investment is a better alternative to basic ROI as it allows you to compare different investment choices. You cannot compare two different investment options using basic ROI on its own if the lengths of the investment options are different. For example, if you were just told that two investment options yielded a ROI of either 1% or 10%, you most likely would choose the 10% ROI option. If you were then told that the 1% ROI option had an investment length of one day and the 10% ROI option had an investment length of 100 years, then you might reconsider your choice.
Annualized ROI allows you to compare investment options with different investment lengths. In the above example, an ROI of 1% after 1 day would result in an annualized ROI of 3,678.34%. An ROI of 10% after 100 years would have an annualized ROI of 0.09%. This allows you to quickly see that even though the basic ROI of the second investment option is higher, the annualized ROI of the first option shows that it would be a better investment. Of course, this assumes that there is the option to reinvest or invest in other investment opportunities.
ROI vs Annualized ROI
|Initial Investment||Investment Gain||ROI||Holding Period||Annualized ROI|
|Investment A||$100||$1||1%||1 Day||3,678.34%|
|Investment B||$100||$10||10%||100 Years||0.09%|
What is ROI in Real Estate?
In real estate, the concept of ROI is the same. That is, it measures how profitable a real estate investment has been relative to the cost of the investment. In a simple scenario, we assume that you bought a property for $150,000 and you sold it 5 years later for $220,000. Your ROI would be:
And the annualized ROI would be:
However, some people that choose to invest in real estate, do so that they can rent the properties out and benefit from collecting rent every month. This needs to be factored in when we calculate ROI, as we will see in the section ROI on Rental Property.
Average ROI in Real Estate
According to the National Council of Real Estate Investment Fiduciaries, for the 10-year ending in the 3rd quarter of 2020, the average ROI in real estate has been at 9.4%. We can see this on the graph below by referring to the NPI, which is NCREIF’s index.
There are 4 main categories of real estate to invest in:
- 1. Residential Real Estate - property used for residential purposes
- 2. Commercial Real Estate - properties used for income-generating services
- 3. Industrial Real Estate - properties used for manufacturing, processing, warehousing, or retail purposes
- 4. Land
Each of these classes differs by the return that they offer to an investor. As seen on the graph, industrial properties offer some of the highest returns in real estate and these returns have stayed positive even during the economic crisis caused by COVID-19.
A good ROI in real estate is considered anything above 8%. However, investors should aim for a 10%-12% return.
ROI on Rental Property
Initially, we calculated ROI as if there were no other cash inflows rather than at the sale of the property. Now we will consider the case, where we rent the property out and collect rental income each month. Things get trickier when we involve various costs related to the purchase, maintenance, and any financial costs such as purchasing a property through a mortgage. All of these will need to be accounted for when we calculate the return on investment in a property.
ROI for rental properties is calculated as follows:
Total Income - To calculate the return on our investment, we will first need to figure out how much income the property will generate. The income usually comes in the form of rent and other income from building amenities.
Operating Expenses - These include the costs associated with the daily operation of the property. Expenses such as property taxes, property insurance, landlord insurance, management fees, maintenance, and minor repairs are included in this category.
Financial Expenses - These include costs associated with purchasing a property by using a mortgage. The interest expense and mortgage payments are to be accounted for in the ROI of real estate.
Imagine that you purchased an investment property for $200,000. To finance the purchase, you took out a 30- year mortgage with a 4.5% interest rate and put a 20% down payment for it. You also paid $3000 in closing costs and $12000 in repairing it.
You decide to rent out the property at a monthly rent of $1500. Maintenance, property taxes, insurance, and utilities will cost you $300/ month.
Using our mortgage payment calculator, you can find out how much your monthly payment will be.
For a 30-Year mortgage at a 4.5% mortgage rate, with a $40,000 down payment, the monthly mortgage payment will be $811 which includes the principal and interest payment.
The cost of investment will equal the down payment you make, closing costs, and any major repairs that qualify as expenditures.
IRR VS ROI
IRR is another financial measure to estimate and compare the profitability of investment opportunities. IRR, or the Internal Rate of Return, is a discount factor. It is the discount factor that makes all the net cash flows from an investment through the years, or the investment’s net present value, equal to 0. When a project’s net present value is equal to 0, it means that the project is neither profitable nor unprofitable. The formula of IRR is:
In terms of usage, while ROI is used mainly for short-term investment opportunities, IRR is more useful in finding the long-term return, because IRR takes into account the timings of the cash flow, while ROI doesn’t. However, as the formula shows, IRR is a bit more complex to calculate than ROI.
It costs $30,000 to make an investment, which will generate net cash flows of $12,000 every year for 3 consecutive years. Calculate the IRR.
ROI on stocks measures the return on investment in a particular stock relative to what it cost you to purchase that stock. The return can be in the form of stock appreciation or depreciation in value and dividend distributed during a period of time.
The formula for Stock ROI is:
Imagine that you bought 1000 shares of ABC company at a price of $20 per share. When you decided to sell off your shares, the price of an ABC share had gone up to $28. During this time, you also receive a dividend in the amount of $2 per share. What was your ROI?
Then we find the net return of the investment, which is the total net return subtracted by the cost of the investment. The cost of investment is the amount that you paid for the shares when you first bought them.
Average ROI on stocks
The historical average ROI on stocks has been around 10% per year since 1926. This average is found by looking at the S&P 500 index, which is considered the benchmark for stock market returns. Taking a look at the 10-year return, according to Goldman Sachs, the annual stock market return is 9.2%.
It is important to stress that this is just an average, meaning that if you decide to invest in stocks, you will most likely not get this exact return. Depending on recent events, ROI on stocks can be higher or lower for a certain year. Experts suggest that you use a 6% annual stock return when you are estimating how much a stock investment will return.
Best ROI stocks in 2020
Despite the economic downturn caused by COVID-19, some stocks still managed to perform well under the new circumstances. Besides technology and electric vehicles, an industry that experienced strong growth was that of medical specialties and biotechnology as companies rushed to provide vaccines and other medicine to fight the pandemic.
As mentioned earlier, the ROI in stock is a result of two components, price change and dividends distributed. For the list of 20 stocks that performed best in 2020, we will focus on only the price change as an indicator of ROI.
|Company||Industry||Price Change during 2020 (%)|
|Tesla Inc.||Motor Vehicles||743|
|Peloton Interactive Inc. Class A||Other consumer services||434|
|Zoom Video Communications Inc. Class A||Software||396|
|Pinduoduo Inc. Sponsored ADR Class A.||Internet Retail||370|
|Etsy Inc.||Miscellaneous Commercial Services||302|
|MercadoLibre Inc.||Internet Software/Services||193|
|Okta Inc. Class A||Software||120|
|PayPal Holdings Inc.||Data Processing Services||117|
|L Brands Inc.||Apparel/Footwear Retail||105|
|Albemarle Corp.||Chemicals: Specialty||102|
|Advanced Micro Devices Inc.||Semiconductors||100|
|Freeport-McMoRan Inc.||Other metals/Minerals||98|
|Cadence Design Systems||Software||97|
|ServiceNow Inc.||Information Technology Services||95|
|Atlassian Corp. PLC Class A||Software||94|
|Align Technology Inc.||Medical Specialties||92|
|Idexx Laboratories Inc.||Medical Specialties||91|
ROI analysis is a valuable tool for comparing different investment proposals. You can use ROI to choose between different investments, different companies or compare performance during different periods. It is crucial to understand what ROI tells us in order to make the most use of it.
Companies use ROI as well, to measure the profitability of their investments. In this case, we used the term Return on Invested Capital, or ROIC, and it is calculated as follows:
This formula can be broken down into two other components, which can help the company do a more accurate analysis of different ROIs.
To get a better understanding of the differences in ROIs in time periods or in different projects, companies can try to locate what is causing these differences - the return on sales or the asset turnover.
Effects of Leverage on ROI
Leverage is when you borrow money to invest. Since you’re borrowing money so that you don’t need to invest as much of your personal capital, your returns will be magnified based on your capital contribution. This can be a good thing for positive returns, but can be bad for negative returns. In other words, leverage makes gains bigger, but also makes losses bigger.
Most homeowners in the United States will need to get a mortgage in order to purchase their home. Did you know that using a mortgage to purchase a home is a form of leverage? Instead of having to pay the full purchase price of the home in cash, you will only need to make a small down payment. The rest of the cost of the home will be financed with a mortgage. Some mortgage types, such asVA loans and some USDA loans, have no minimum down payment requirements at all! In return, you get to keep all of the home’s price appreciation.
Leverage and Real Estate ROI
Calculating ROI for real estate and rental propertiesinvolve leverage, which can affect the ROI calculation. You will also need to take into account additional costs, specifically financing costs. Let’s look at a $500,000 home in Los Angeles that is being financed with a FHA mortgage loan that has a minimum down payment requirement of 3.5%. This means that you will need to pay $17,500 today in exchange for owning the home. Let’s say that in five years the price of the home is now $550,000. The price of the home went up $50,000, but you only had to “invest” $17,500. That’s a 185% return on your investment!
If you didn’t use leverage and purchased the home using cash only, how much will your ROI be? You would need to have paid $500,000, and gotten a $50,000 gain. That would be a 10% return on your investment for the same property, which is much lower than getting a mortgage and getting a 185% ROI.
However, you will most likely not be able to borrow money for free. Mortgage lenders chargemortgage interest, and other forms of leverage have some type of financing cost as well. Let’s say that your mortgage rate is fixed at 3.0%. Would you still have a positive ROI? Using a mortgage interest calculator, we can see that it would cost about $1,150 in interest per month for a $500,000 mortgage, which includes closing costs. Over five years, that would be roughly $69,000 in interest! That’s more than the $50,000 capital gain from the home’s price growth. This means that rather than a 10% ROI from not using leverage, you will have a negative ROI of 38% by using leverage after accounting for financing costs.
A quick way to see how leverage will impact your ROI is by comparing the investment’s financing costs with the investment’s total return. In this case, the financing cost of the mortgage was 3% per year. However, the home price only grew by 2% per year. This means that the home will have a negative return of 1% per year.
While real estate can have a high level of leverage, other types of investments might have lower leverage limits. For example, stocks in the US commonly have a maximum leverage of 2:1, or 50%. For example, with $10,000, you can purchase up to $20,000 of stocks using margin.
Knowing the benefits and costs
It is true that ROI is an easy metric to compare different investment opportunities. However, you cannot use ROI to measure some returns that are intangible, such as social impact and environmental consciousness. So when you do use ROI to evaluate investments, make sure you have a clear idea of what these costs and gains comprise.
Let’s say your company is planning to purchase a new machine that will help its business. The first machine has a ROI of 12%. The second machine has a ROI of 8%. If we simply compare the numbers, obviously that you would go with the first machine. However, what if the lower ROI of the second machine was because of its higher cost due to it being environmentally friendly, which investment would you choose now? Companies that place higher importance on social responsibility would probably choose to purchase the second machine.