Individuals or companies that invest money have every right to ask, “What’s in it for me?” Whether it involves funding a retirement account for a millennial or a piece of capital equipment purchased by a business owner, knowing what you’ll get in return for your dollars is paramount. We’ll help you break down the return on investment (ROI) ratio — what it is and how it’s calculated.
What Is the Return on Investment Ratio?
ROI analytics is a vital tool for businesses and individuals. Whether you’re a business owner looking to turbocharge revenue or an investor in search of the next explosive stock, the ROI ratio holds a lot of value. The calculation is a straightforward method that indicates if a past investment was a worthy one, or if that decision needs to be re-evaluated.
There are two separate methods to figure out ROI. In one method, you’ll look at your beginning investment of dollars spent and dividing your net return by that initial cost. As an alternate method, subtract the initial value of the investment from the final value of the investment and divide that difference by the starting amount of the investment.
Either method will give you the same result, expressed as a percentage. In the first case, you will have already established your net return, and in the second example, you’ll need to factor in a beginning and ending value to arrive at net return. Which method you use will likely depend on the tools and data you have at your disposal. Some software programs may yield a net return while manual calculations may require another step.
Return on Investment Ratio Formula
Let’s take a look at determining ROI in practice. If you want to calculate return, simply plug some prescribed variables into either of the two equations below:
ROI = Net Return on Investment / Cost of Investment × 100%
As an example, let’s say $20,000 in revenue was generated from an enhanced marketing effort and expenditure of $100,000. Therefore, we can plug in the variables as such:
ROI = $20,000/ $100,000 × 100%
And arrive at our ROI:
ROI = 0.20 × 100% or 20%
ROI = Final Value of Investment − Initial Value of Investment
/ Initial Cost of Investment × 100%
Sticking with the advertising campaign scenario, we need to add the additional revenue to the initial investment to get our first value, and then we’re off to the races:
ROI = ($100,000 + $20,000) − ($100,000) / $100,000 × 100%
ROI = $20,000 / $100,000 × 100%
There’s an extra step but we see the same result:
ROI = 0.20 × 100% or 20%
What Is a Good Return on Investment Ratio?
If you want to know what constitutes a good return on investment, the answer is usually this: It depends.
While arriving at ROI is fairly simple for straight-dollar dump-ins on personal securities investments, assessing all the factors on the business side of the equation is a bit more complex, especially with regard to assessing return.
If you’re a growth investor placing that same $100,000 investment in a stock or other security that earns 12% per year, there’s probably a job for you on Wall Street. All kidding aside, that ROI, were it achieved year after year, should please any investor. Yet, should you have expected 15% or even 25% in return?
For individual investors, a “good” ROI is relative, and it’s usually compared to a benchmark.
Each year, all professional money managers actively seek to best the percentage return of the S&P 500 Index. This index reflects the aggregate stock price performance of the largest 500 publicly traded companies in the United States. To put the S&P 500 in terms of ROI, the index historically returns about 7% annually on average. If the market mavens on “The Street ” consider beating the index a job well done (and they do), then so should you.
Of course, you might want more or even settle for less. Growth investing is often looked at as a strategy aimed at making your dollars outpace the rate of inflation, which runs about 3-3.5% per year on average, depending on whom you consult. So, if that’s your objective, a 6% annual average return might meet your expectations.
So, what about the business owner or executive who wants to gauge performance? For large corporations that must answer to shareholders and maintain a team of internal analysts, there’s a wealth of financial data to compare ROI on past projects. Stock analysts outside the company confine ROI comparisons to organizations in similar industries: a bank with a bank or a retailer with a retailer. Thus, if your ROI leads the pack among your peers, you can certainly define that as “good.”
With small business, the benchmarks may be tougher to establish. Data and competitor information is less plentiful at that level but you could consider ROI in terms of how quickly the initial investment is recovered. If you could coax an 18% ROI out of that $100,000 ad campaign, you will have recovered your upfront costs in 4 years.
For a business that’s spending $100,000 on a new advertising campaign, the upfront investment amount is easy enough to calculate. However, the actual return in dollars requires more careful analysis. If your sales rose by $50,000 since you launched this new ad initiative, you might reasonably conclude that your idea was responsible for the total increase. However, you shouldn’t assume that your marketing efforts alone led to the boost.
There could be any number of reasons for that good news. Those variables might have included a price increase, a reduction in the cost of goods or services or an extraordinary effort on the part of your sales team.
You can get closer to the true ROI for individual assets or pursuits such as advertising, however.
Let’s assume your sales grew $30,000 in the time period before the marketing plan was implemented. You can then deduce that the additional $20,000 in revenue was due to the new initiative when measured over a similar time frame— perhaps a quarter or a fiscal year.
This also illustrates a shortcoming with ROI measurement: There’s no allowance for time. A 20% ROI in a single year might look fantastic, but spread over 5 years — not so much. That’s an easy fix, though. Simply measure your investment dollars and the return in dollars over any timeframe you choose, and compare ROI to the previous period, such as year-over-year or month-over-month.
What the ROI Ratio Means for Your Business
A beautiful ROI is truly in the eye of the beholder. Individual investors and businesses large and small all have different goals and objectives. The key to achieving a laudable return in business lies in your ability to innovate and execute. For individual investors, ROI is at the mercy of the capital markets and is more difficult to control. But, history tells us that patience and discipline with investments usually pay off over the long haul.