DEFINITION: The phrase “return on investment (ROI)” refers to a metric for assessing the effectiveness or profitability of an investment.
Additionally, ROI is useful for comparing the efficiency among various investments.
However, the primary aim of ROI is to provide a quantitative measure of the profit generated by a specific investment compared to its initial cost.
To compute ROI, the profit from an investment is divided by its cost. This result is presented as a percentage.
ETYMOLOGY: Both the concept and the phrase “return on investment” were introduced in 1914 by DuPont Company executive Frank Donaldson Brown.
The English noun “return” is attested from the fourteenth century. In the verbal form, it derives from Middle English retournen and Middle French retourner, from the particle re-, meaning “back” or “again,” and the Medieval Latin verb tornare, meaning “to turn on a lathe,” which itself derives from the noun tornus, meaning “lathe.”
The English preposition “on” derives from Middle English an, and the same form in Old English. The latter is akin to Old High German ana.
The English noun “investment” is attested from the seventeenth century. It derives from the verb “to invest,” which derives from Medieval Latin investire, meaning “to clothe.”
USAGE: Return on investment may be calculated using the following formula:
ROI = (CIV − COI) / COI
where
ROI = return on investment
CIV = current investment value
COI = cost of investment
Note: the term (CIV – COI) equals the profit on the investment, which is a distinct concept from ROI.
The term CIV (“current investment value”) refers to the earnings obtained from the sale of the relevant investment.
Since ROI is expressed as a percentage, each such calculation may be compared in a straightforward fashion with returns from other investments, facilitating the evaluation of different kinds of investments in relation to each other.
For example, consider the following case: Anna allocated $2,000 to Red Country Company in 2022 and sold the shares one year later for a cumulative sum of $2,400.
To compute the ROI for Anna’s investment, we plug these values into the formula given above:
ROI = (2400 – 2000) / 2000
ROI = 400 / 2000
ROI = .2
ROI = 20 percent
The popularity of ROI calculations is due to their simplicity and adaptability. In essence, ROI can serve as a basic indicator of an investment’s profitability.
ROI calculations may be performed in a wide variety of investment contexts, including stock purchases, physical plant expansion, or real estate transactions.
The computation itself is not difficult, and its broad applicability makes it relatively easy to understand.
When an investment’s ROI is in positive, it generally indicates a solid investment. However, there may still be alternative opportunities for investment available that would have a higher ROI.
In this way, ROI may provide cues which may assist investors in choosing the most favorable investment.
Conversely, a negative ROI, which suggest a net loss, should obviously be avoided by investors.