Understanding Return on Investment
ROI is a performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. ROI measures the amount of return on an investment relative to the investment’s initial cost. To calculate ROI, the return of an investment is divided by the cost of the investment, and the result is expressed as a percentage or a ratio.
Because this is measured as a percentage, it can be easily compared with returns from other investments, allowing one to measure a variety of types of investments against one another.
Return on investment is a very popular metric because of its versatility and simplicity. Essentially, return on investment can be used as a rudimentary gauge of an investment’s profitability. ROI can be very easy to calculate and to interpret and can apply to a wide variety of kinds of investments. That is, if an investment does not have a positive ROI, or if an investor has other opportunities available with a higher ROI, then these ROI values can instruct him or her as to which investments are preferable to others.
Potential Limitations of ROI as a measure
Cursory comparison of investments using ROI can lead one to make incorrect conclusions about their profitability. Given that ROI does not inherently account for the amount of time during which the investment in question is taking place, this metric can often be used in conjunction with Rate of Return, which necessarily pertains to a specified period of time, unlike ROI. One may also incorporate Net Present Value (NPV), which accounts for differences in the value of money over time due to inflation, for even more precise ROI calculations. The application of NPV when calculating rate of return is often called the Real Rate of Return.
The means of calculating a return on investment can be modified to suit the situation therefor. It all depends on what one includes as returns and costs. The definition of the term in the broadest sense simply attempts to measure the profitability of an investment.
As calculations can be easily manipulated to suit the user’s purposes, and the results can be expressed in many different ways, when using this metric the savvy investor would do well to make sure he or she understands which inputs are being used. A return on investment ratio alone can paint a picture that looks quite different from what one might call a more accurate ROI calculation and investors should always be sure to consider the bigger picture.
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