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What is Return on Investment?

Notes from the video ‘Diffusion Academy| Finance |What is Return on Investment?‘ :

What is Return on Investment?

Return on investment, or ROI in short, measures the gain or loss from an investment relative to the cost of the investment.

We can calculate ROI by dividing the net profit from an investment by the cost of the investment.

Let’s look at an example:

Jane purchased a property two years ago. The property was valued at \$1 million dollars then.

Today, she sold the property for \$5 million dollars.

To calculate the return on her investment, we can use the ROI formula.

First, we need to get the net profit of her investment.

We need to subtract the cost of investment which is \$1 million from the amount she sold her property for, \$5 million in this case. After which, we get \$4 million as her net profit.

Next, we divide the net profit by the cost of her investment, which is \$1 million in this case, and multiply it by 100% which gives Jane a ROI of 400%.

ROI calculation is commonly used because it’s simple and flexible.

A company can use the calculation to compare the returns on different business activities while an investor may use it to calculate the return on a stock.

For example, an investor could calculate the ROI for different companies and invest in the company with the highest ROI.

However, ROI calculation has several limitations.

Firstly, return on investment calculations can be manipulated by companies to mislead investors.

Since ROI is calculated from net profit and costs, a company can easily manipulate its ROI by selectively adding or removing components of revenue and costs to suit the situation.

For example, if a company wants to inflate the ROI, it could exclude some cost components from its ROI calculation.

Also, ROI does not take important factors like time into consideration.

Let’s assume we have two projects with the same ROI of 20% but we only have enough resources to complete one project.

Project A takes 1 year to complete, and Project B takes 3 years to complete.

In this scenario, if we use ROI as the only metric, both project would be equally desirable.

However, if we were to factor time into the decision-making process, Project A would be a better choice since it frees up more time and more cash for us to work on other projects which will in turn bring in more profits.