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A smart investor’s guide to Calculating Return on Investment (ROI)

Every investment is made to earn a return. Tracking performance regularly is necessary. It is more relevant for market-driven investments like mutual funds. Return on Investment (ROI) is one metric that’ll help in understanding the performance of an investment.

return on investment (roi)
Return on Investment (ROI)

What is Return on Investment?

Every investment is made with a purpose. One way to check whether the investment is achieving the target is by checking potential returns. Understanding the potential gains will help in deciding whether or not to invest in the asset class. Checking the historic ROI will help in understanding the performance trend of the asset.

When an investment delivers promised returns, it is considered to be an excellent investment option. ROI is relevant for both equity and fixed income instruments. It is a profitability ratio. One can use ROI for comparing investments. ROI helps in understanding an investment return and optimize the investment portfolio.

What are the different ways to calculate ROI?

One can use the following methods to calculate ROI:

  • Net income method
  • Capital Gain method
  • Annualized ROI

Return on Investment ROI Formula

The ROI Return on Investment formula is simple and straightforward. ROI is a percentage of increase or decrease in the value of the investment. To calculate ROI one can use either of the following three formulas:

Net income method ROI = (Net Return on Investment/Cost of Investment)*100

(OR)

Capital Gain method ROI = [(Final Value of Investment – Initial Value of Investment)/Cost of investment]*100

(OR)

Annualized ROI = [(1+ROI)^1/n – 1]*100%, where n is the number of time periods (in years) the investment is held.

How to Calculate Return on Investment?

ROI Return on investment is a metric to measure the profitability of an investment. It measures the gain of an investment over and above the investment cost. It is a simple ratio of net profits relative to the costs of the investment. ROI is a percentage, and hence it is easy to compare with the profitability of other investments.

Calculating the value of ROI can be done by using either of the above three methods. Let’s take an example of Mr Anurag, who has invested in INR 50,000 in a mutual fund scheme. Three years down the line, at the time of redemption, the value of the investment is INR 80,000. Anurag can calculate the ROI using the methods mentioned above.

Method 1: Net Income Method

The basic ROI formula is

ROI = (Net Return on Investment/Cost of Investment) *100%

Net Return on the investmentINR 30,000 (80000-50000)
Cost of the investmentINR 50,000
ROI60% ((30000/50000)*100%)

Method 2: Capital Gain method

ROI = ((Final value of Investment-Initial value of investment)/Cost of investment)*100%

The final value of the investmentINR 80,000
The initial value of investment or cost of the investmentINR 50,000
ROI60% ((80000-50000)/50000)*100

The cost of investment is similar to the initial investment. The return on investment is 60%. This can be easily compared to other investments, which will help in decision making. But mutual fund‘s return is stated as an annualized, and the above return is absolute return. Hence Anurag can also calculate the ROI using annualized return formula.

Method 3: Annualized ROI method

Annualized return can be calculated using the following formula:

Annualized return = [(1+ROI)^1/n – 1]*100%, where n is the number of years the investment is held.

Hence the annualized return for Mr Anurag is [(1+60%)^1/3 – 1]*100% = 16.96%. This 16.96% is the annualized return. This means the investor, on average, earned a 16.96% return each year for three years. Hence the investment grew from INR 50,000 to INR 80,000.

How to interpret ROI?

Return on Investment ROI has become very popular in capital purchases, investments, business decisions and venture capital investments. For business decisions, ROI is a measure of net returns over total investment costs.

For investment purposes, ROI measures the increase in the value of the investment as a percentage of the initial investment. Similarly, in mutual funds, too, ROI measures the increase in the value of the investment. In other words, it measures the profitability of an investment.

The ROI is a percentage value. ROI can be positive or negative. In other words, the investments return can be positive or negative.

When the ROI is positive, it means that the total returns exceed the initial investment. On the other hand, when ROI is negative, the total returns are lower than the initial investment. Positive ROI indicates that the portfolio is making profits, while negative ROI means losses.

One can use the ROI of similar periods to compare different investments. Comparing the ROI of two different periods is the biggest mistake one can make. Higher the ROI of an investment, better is the profitability. And one should always pick investments with high ROI while comparing two investments.

Advantages & Disadvantages of Return on Investment

Advantages of Return on Investment

The advantages of Return on Investment are

  • User-friendly: Calculating the value of ROI is straightforward and simple. All that an investor needs to know is the cost of investment and net profits of the investment. To determine ROI value, it doesn’t require the help of any financial expert.
  • Widely used and understood: The ROI formula is used across the world. It is a universally accepted concept. One can easily determine ROI, and it is also simple to interpret and explain to people.
  • Versatile: ROI is a simple but effective parameter to make an investment decision. It has many applications such as understating profitability of a scheme and for comparative analysis, among others.
  • Better financial management: ROI helps in the better financial management of the investor’s portfolio by aiding them to take investment decisions.

Disadvantages of Return on Investment

Following are the limitations of ROI:

  • Ignores the time value of money: Different schemes have different maturities and tenures. ROI of a one-year Fixed Deposit cannot be compared to a three year ELSS. The rate of return is a performance metric.
  • Doesn’t consider Inflation: ROI doesn’t take into consideration the reduced value of money due to inflation and additional expenses like processing fee, stamp duty, etc.
  • Results are easy to Manipulate: Results vary from investor to investor. Therefore, only when the same inputs are used, the exact value can be determined.

What is the difference between ROI and ROE?

Return on Investment or ROI is a financial ratio that helps in determining the profitability from a particular investment. ROI is relevant for both equity and fixed income instruments. It is a profitability ratio. The basic ROI formula is

ROI = (Net Return on Investment/Cost of Investment)*100

(OR)

ROI = [(Final Value of Investment – Initial Value of Investment)/Cost of investment]*100

ROI is an essential indicator that helps investors measure their profitability from a particular investment. To compare the returns from various investments before making investment decisions, businesses often use ROI. It also helps in the better financial management of the investor’s portfolio.

On the other hand, the return on equity is a financial ratio that measures the company’s profitability/performance in relation to equity. In other words, ROE measures the effectiveness of the management in using the company’s assets to generate profits.

The basic formula for Return on Equity ROE is  

Return on Equity ROE = Net Income/Average Shareholders’ Equity

ROE gives a good picture of the financial and business decisions made by the company.

What is CAGR?

Compounded Annual Growth Rate (CAGR) is an average annual growth rate of an investment. One can use CAGR to determine the growth rate of an investment for a period greater than one year. Compounded Annual Growth Rate is one of the most accurate ways to determine the returns from an investment.

Usually, mutual fund or stock market investments do not give constant returns every year. These are volatile investments, and hence returns vary. Additionally, when regular re-investments are made, it is important to know the profit earned on all investments together. Therefore, CAGR will help in calculating the return earned during the investment tenure. However, Compounded Annual Growth Rate is applicable only in the instance where the gains are reinvested every year.

How to calculate CAGR?

Compounded Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a period of time, which is usually more than one year. 

The basic formula for CAGR is

CAGR = ((Final value of the investment/ Initial value of the investment)^(1/n)) – 1

Where, n is the number of time periods, usually in years.

It will help in calculating the return earned during the investment tenure.

Let’s take an example of Ms Divya Kumar, who invested a lump sum amount of INR 1,00,000 in mutual funds in 2015. In 2020, her value of investment is INR 1,65,000.

The CAGR return for Ms Kumar would be

CAGR = ((165000/100000)^(1/5))-1

CAGR = 10.53%

This means her investment is growing at an average rate of 10.53% per annum.

Can a return on mutual funds be negative?

Yes, return on mutual funds can be negative. Mutual Fund investments are subject to market risks. In other words, mutual funds are market-linked instruments. Hence are volatile.

Returns from the scheme depend on its performance. And, if the stocks in the fund portfolio do not perform well in the stock market, it impacts the fund’s performance. Therefore, mutual funds do not guarantee returns.

However, SIP investments with a long investment tenure may help in averaging out the risk associated with mutual fund investments.

To know more about mutual fund investments, use our beginners guide to investing. Scripbox helps investors build their financial plan. Having goals in place makes it easier to choose a financial plan and invest in it.

Can I improve ROI?

One can improve their Return on Investment from a portfolio by following the below strategies.

  • Rebalancing your portfolio

Every portfolio has investments that are not performing well. This calls for rebalancing the portfolio by liquidating the investments that aren’t performing well and investing in better-performing ones.

  • Diversification

Diversification helps in balancing the risk in a portfolio. At the same time, a concentrated portfolio can either give high returns or losses in the bull and bear phase of the market, respectively. However, a diversified portfolio can help in balancing out the portfolio risk. Profits from others offset a loss from one investment. This ensures the portfolio return is at least close to the expected return.

  • Reducing the costs of investment

Investors have to invest with a goal in mind. They will have to keep monitoring their portfolio periodically. And only rebalance it if the investment goal is not being met. Investing for very short tenures, panicking for small market moves and churning the portfolio often will only increase the costs of investment. To increase the returns from a portfolio, investors have to cut down on the costs.

Is ROI and Internal Rate of Return (IRR) the same?

Return on Investment (ROI) and Internal Rate of Return (IRR) are often used interchangeably. However, IRR is used when there are multiple cash flows. For example, in mutual funds. In SIP investments, there are multiple cash flows (outflows) for an investor over a period of time. To calculate the return from SIP investments, one can use IRR. On the other hand, to calculate returns from lump sum investments one can use ROI.

The formula to calculate IRR manually is:

ROI - Return on Investment

Where NPV is the net present value

This method set a value of zero to the net present value NPV to calculate for r.

However, one can also use an excel formula to calculate their returns from SIP investments.

Published on March 13, 2020