Intro
ROI is the abbreviation for return on investment and it allows you to measure your return on investment. For example, it can be a direct cash investment – such as measuring the ROI of stocks, investment portfolios, or asset acquisitions such as real estate. It can also be used to measure the return on business efforts.
There are 2 ways ROI is used:
- to calculate the projected return on an investment, which is done once you determine whether or not the investment is worth the cost
- and the actual ROI, which is calculated after the fact to measure what kind of return you have actually seen.
Here we go into detail on everything an entrepreneur needs to know when it comes to ROI. As you master investment calculations, check out our selection of free courses to discover more ways to spread your business insight.
Return on investment (ROI) – what is it?
A return on investment, commonly abbreviated to ROI, is a simple metric that quantifies the profitability of an investment. Essentially, ROI measures how much you have earned from an investment compared to how much you have invested in it. It is a metric that businesses and investors use to make a determination of the value of their investments.
For capital investors, ROI is often calculated in strictly financial terms. The amount of capital you have invested and how much have you received back? For businesses, ROI is often measured by using different indicators. There is the pure monetary cost of the amount a business invests in a particular business project or initiative, but then there are also so-called soft factors, like the time different employees have dedicated to the project. Some of these can be financially measured.
If an employee who earns $100,000 a year works a full month on a certain project, for example, you would need to make a profit of at least $8,333 to reach break-even on that project. On top of the salary costs that have been allocated to the project, there is also the issue of convenience cost. So what else couldn’t employees work on because they were engaged in that project? As time is a finite resource, many businesses will also try to factor in the cost of time and the concessions they will have to make to continue a particular project, even if these factors cannot be measured in a quantitative way.
How to express ROI
By percentage: It is the most common way of expressing ROI because it is the easiest to understand. If you made a $10 profit on a $100 investment, this would be expressed as a 10% ROI.
As a ratio: ROI is a proportion, but this is less used because it can be harder to understand if the ROI is less than 100%. In the example above, the ROI would be expressed as a ratio of 0.10:1. It’s weird, isn’t it? But consider an ROI of 500% or 1,000%, in these situations it may be simpler to show the ROI as 5:1 or 10:1.
As a multiple: Stating ROI as a multiple is a version of stating it as a ratio. In the example above, you could say that the ROI was 5x or 10x instead of 5:1 or 10:1. Once again, this is best used for ROIs greater than 100%.
Measure the ROI
A basic ROI measurement can help you make financially strong decisions. Let’s look at the step-by-step method of calculating ROI.
- Get started by collecting the necessary data for the ROI equation.
- Cost of investment: Calculate the total cost of the investment. That might include capital investment, marketing investment, and salary/staff costs that went into the investment.
- Net profit: Net profit is determined by deducting the cost of the investment from the gross profit (i.e. total profit).
- Divide the net profit by the cost of the investment.
- Multiply the result by 100 to get a percentage.
Key ROI formula
To calculate ROI, there are two different formulas. You can choose to use either of the 2 ROI formulas.
- ROI = (Net Profit/Cost of Investment) x 100
- ROI = ([Present Value-Cost of Investment]/Cost of Investment) x 100
The result of both formulas will be the same. Using the second ROI formula simply details the steps to calculate the net profit, representing the gross profit minus the cost of the investment, prior to dividing it by the total cost of the investment.
By looking at an ROI equation, it may seem confusing in the abstract, so let’s take a look at how ROI is calculated by using a few examples.
Measure the ROI – the ROI calculation for a marketing campaign
Deciding based on ROI is what may differentiate your marketing department, so let’s see how a hypothetical e-commerce company, Buy Cute Stuff, might calculate the ROI of its “Buy 1 get 3 for free” campaign.
The investment cost ( trading cost)
Buy Cute Stuff ran a social media ad campaign announcing to their consumers that they can buy a product and get 3 for free. They placed ads on Facebook and Google that directed customers to a landing page. To calculate their total investment, we need to add up the total spend on ads across different platforms and the price paid for marketing creatives.
- Facebook ad spend: $5,000
- Google ad spend: $7,500
- Social media and ad graphics: $1,000
- Landing page creation: $700
- Total Cost of the Investment: $14,2000
The net profit (sales growth)
The Buy Cute Stuff campaign was conceived to stimulate e-commerce sales, directly increasing revenue. To calculate the net profit of their marketing campaign, we should consider the overall revenue generated by the campaign and then deduct the total cost of investment.
In that context, the total sales generated by the campaign are $60,000
Net Profit = $60,000 – $14,200 = $58,578
Marketing ROI = ($58,578/$14,200) x 100 = 413%
To conclude, we should underline the fact that the total ROI of this campaign is 413%. It can also be expressed as a ratio (4:1) or a multiple (4x).
An alternative way to determine marketing ROI
A different way marketers tend to measure ROI is through customer lifetime value (CLV). CLV reflects the long-term ROI of a loyal customer. You can measure CLV with the following formula:
Customer Lifetime Value = (Retention Rate) / (1+ Discount Rate/Retention Rate)
How about a good ROI?
A good ROI depends on the type of investment. In marketing, 500% (i.e. 5:1 or 5x) are a solid ROI. 1,000% (10:1 or 10x) is considered to be stellar. At 200%, on the other end, would be considered disappointing. When investing in stocks, a 7% yearly ROI is regarded as the standard, and an ROI of over 10% is considered to be good in real estate investing.
Unless you’re uncertain whether or not your ROI is good for a specific sector or project, do some market research to see what the standards are for comparison.
Tips for using ROI
ROI can be used to calculate the value of almost any expense. It is typically used by investors to calculate the return on capital compared to their initial investment and is used by businesses as a key performance indicator (KPI) to quantify the value of different investments.
ROI makes it easier to take the assumptions out of business decisions, giving you the information you need to make a strong investment decision. ROI is often used by businesses to measure the cash value of:
- Recruiting new staff
- Buying equipment
- Marketing efforts
- Selling strategies
- Expanding the company
- Buying another company
Planning ROI for upcoming business decisions
Companies often use ROI as part of a cost-benefit analysis before embarking on a new project or expenditure. As an investment formula, ROI is only as trustworthy as the data you enter into it. Instead, try to be as objective as possible about the costs involved and the total return you can expect. Also like any projection, ROI can be inexact if the predictions you make are too optimistic or too negative.
As you evaluate whether or not to proceed with a project, you must also consider the cash flow generated by your business and how the required investment will affect your cash flow. If you currently have $10,000 of working capital and it would cost $8,000 to buy new machinery, this is a high-risk investment as it consumes 80% of your cash – even if the potential return on investment makes it look valuable from a long-term perspective.
Is there anything ROI can’t do?
ROI has nothing to report about the potential risk of an investment. It can’t tell you whether you have the money to profit from a new investment opportunity, and it can’t tell you whether a digital marketing campaign supports your overall marketing strategy. As well it is impossible for ROI to measure your team’s job satisfaction. Don’t forget about this!
To summarise, ROI doesn’t allow for any nuances. It’s one factor that should be taken into account when weighing the advantages and disadvantages of an investment opportunity, but it should never be the only basis for a financial decision.
ROI vs IRR – are they the same?
A lot of people question whether ROI is the same as internal rate of return (IRR), as IRR is commonly referred to as “return on investment”. However, ROI and IRR are different in terms of the way they are calculated. IRR offers several nuances, but because it is more complex to calculate, it tends to be used only for equity investments (and usually only by investment professionals).
How to define the annualised ROI?
An annualised ROI is the measurement of the average ROI of an investment on a yearly basis. Investments that are long-term, such as stocks and real estate, tend to be calculated in annualised ROI.
The formula to measure the annualised ROI is slightly more complex than the basic ROI calculation. Here’s how annualised ROI is measured:
Annualised ROI = {[1 + (Net Profit / Cost of Investment)] (1/Number of Years Holding Investment) – 1} x 100
The use of annualised ROI for a property investment
An investor who has bought a real estate property as an investment will often use an annualised ROI to quantify the return on investment. The reason for this is that property tends to be kept for a period of years and the cost of the investment is often annualized. Going into a rental property, you will either get a mortgage that analyses the cost of the property or you will pay cash. Even if you pay cash for the property, however, the cost of the property (including the cost of ownership and closing costs) will likely be amortised over the number of years you own it. Doing so will be offset by the appreciation of the asset over time, combined with the rental income the property earns.
In conclusion
Return on Investment (ROI) plans must be implemented effectively for enterprises and organizations in every sector. Resources and investments are optimized with the aid of ROI strategies, which also guarantee the intended outcomes. Organizations can assess the efficacy of their tactics and improve their approach for better results by establishing clear goals and tracking the results.
Organizations can develop a devoted client base and see sustainable growth in the long run by iterating on their strategy frequently and concentrating on providing value to their target audience. Businesses and organizations may maintain their competitiveness in today’s dynamic marketplace and find long-term success by putting in place strong ROI strategies.
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