Return on investment, commonly called ROI, refers to the amount made or lost on an investment and is usually displayed in percentiles. There is no "normal" return on an investment because every investment has different risk characteristics that affect the desired return. So when speaking of returns on investment, professionals will not use the term "normal return." Instead, you will notice that certain returns are labeled as "average," or that others are called out as having higher than expected returns.
Basic Return on Investment Calculation
The mathematical calculation for determining ROI is fairly simple, as long as you have a calculator handy. According to Investopedia, simply take the initial cost of the investment and subtract this from the investment's current value. Then, divide this number by the original cost of the investment. Multiply this number by 100 and you will have the ROI in percentage terms.
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For a hypothetical, let's say that you invested $100 originally and this investment is now worth $150 dollars. The ROI is calculated as: 150-100/100)*100, which equals 50 percent. Another way to think about this looks like this:
- 150-100 = 50
- 50/100 = 0.5
- 0.5 x 100 = 50 percent
Important Caveat Concerning ROI
The ROI is a helpful tool for measuring investment returns after they have materialized. However, it is not as good at evaluating future investment decisions on its own, because it does not adequately deal with the risk or probability of an investment working out.
To ensure that you have a clear picture regarding your investment portfolio, other analysis tools should be used in accordance with ROI. These tools and calculations include Net Present Value, or NPV, and Internal Rate of Return, known as IRR. When you combine these tools with ROI, you will be much better prepared to make wise financial decisions.
Understanding Internal Rate of Return
In the investment world, the Internal Rate of Return is more commonly used when evaluating different investment opportunities. The Corporate Finance Institute reports that the IRR is the discount rate that results in a net present value of zero and is the expected rate of return on that investment.
Just like the Return on Investment, the higher the IRR, the more desirable the investment for investors. The main difference between ROI and IRR is that the IRR considers the timing of the investment under consideration. This makes it a more difficult metric to calculate, as well as a better indicator for making sound investment decisions that serve you well for the long haul.
Net Present Value Basics
Net Present Value refers to the present expected value of an investment under consideration. It is calculated by discounting the expected value of an investment to its worth in current dollars. In other words, NPV is the amount of money that a future sum of money is worth based on the risk characteristics of obtaining that future sum of money. NPV measures the current value of future cash flows, whereas ROI measures the static return on a given investment. Including NPV in your investment analysis can help you gain a more nuanced picture regarding what is and is not possible in a particular investment scenario.
Consider Also: Pros and Cons of Return on Investment, and How to Calculate Net Present Value of a Future Pension