Return on investment (ROI) is also called the rate of return (ROR) and is a measure of the performance of any investment. It is the ratio between the financial benefit or loss of an investment and the amount of money invested.
Return on Investment: Calculation
The return on investment can be calculated by the following formula:
ROI = (Net Income / Cost of Investment) x 100,
ROI = Return on Investment
Net Income = Income from investment - Cost of Investment
The return on investment is always expressed as a percentage. For instance, if the cost of investment is $20,000 and the gain from the investment is $22,000, then the net income will be $22,000-$20,000, or $2,000, and the ROI will be ($2,000/$20,000) x 100 = 0.1 x 100, or 10%.
In case the ROI is negative, it means the cost of investment is higher than the benefits (income) from that investment.This indicates a loss and this investment should not be considered.
ROI and Time
The calculation of ROI does not indicate the duration of the investment. It does not reveal the gestation period.
ROI and the Rule of Thumb
There are certain rules of thumb that make it easy to introduce the concept of time in ROI. These rules assume that the annual rate of return is constant and that the ROI is compounded once a year.
Rule of 72: This indicates how long it would take to double your investment. To calculate this, divide 72 by the ROI. For instance, if the ROI is 10, then the time it would take to double this investment is 7.2 (72/10) years.
Rule of 114: This indicates how long it would take to triple your money. To calculate this, divide 114 by the rate of return. In the above case, it would take 11.4 (114/10) years to grow your money threefold.
Rule of 144: This calculates how long it will take to grow your money four times. In the example considered, the time taken to quadruple your money is 14.4 (144/10) years.
While these are fairly good estimates, they are by no means accurate.
A proper understanding of ROI is a prerequisite for investing wisely. So, don’t forget to calculate and compare the ROI of the various investments you are considering.