Return on investment which is abbreviated as ROI is a percentage. It shows the net income gained from the investment activity, as a percentage of the total sum. Net income is the difference between the amount gained and the cost of the investment. Each investment earns a certain amount of money over its lifetime. Thus, the sum total of all these cash inflows, along with the sale value, form the 'gains from investment'. The 'cost of investment' is the amount you pay to acquire it.
Calculating Net Income
Another important question we need to sort out is how to calculate net income. It is important because, in order to calculate the ROI, we need to find out the net income first. This is a slightly difficult procedure. Let us see it. For e.g., say you have invested in real estate by purchasing a property without a mortgage loan, i.e. with your own money. Let us assume that this land has cost you $2000. Add brokerage charges of $200 and the total cost of acquiring the investment becomes $2200. Now you are going to let this land out on rent, at $500 a year. You hold on to this land for 5 years and then you sell it for $7000. So what is your total earning?
You will be tempted to think that it is $500 * 5 yrs* 12 months + $7000 for sale of land. Actually it is not that way. In finance, it is said that money that is in hand today, is more valuable than the money in hand later. This is because of economic factors like inflation, that play a part in making the currency less valuable in the future than it is today. Hence, you are supposed to discount the value of these cash inflows over the 5 years at a predetermined percentage. This percentage will be suggested by experts in the field, to help you calculate the net inflow. There are tables given for this purpose, to calculate the present value for a stream of inflows (in this example rent) and the lump sum (sale of land). This table gives the factor to be multiplied for any percentage for any number of years. Suppose the rate is 5%, then you are earning $500 * 4.329 (Present Value Interest Factor for Annuity, 5yrs, 5 %) + $7000 * 0.784 (Present Value Interest Factor for lump sum, 5yrs, 5%) = $2164.5 + $ 5488 = $ 7652.5. This amount is your gains.
Formula to Calculate Returns
Once you've come to grips with the gains from investment, then calculating the ROI is easy. You have now found out all the required details and now you just have to fill them into the formula. The formula to calculate the return on investment is:
(Gains from investment - Costs of investments) / Costs of investments * 100
Substituting the calculated values in the formula,
($7652.5 - $2200)/ $2200 * 100
= 247.84 %
So, if you are able to pull off this investment proposition, you are earning a whopping 247.84% of your invested amount!
Why to Calculate it?
The ROI calculation is important to compare two different investment opportunities. Suppose you had $2000 and 5 different investment propositions before you, how would you pick one? The ROI method helps you select the best investment plan. Hence, it would help you choose the plan which gives you more returns.