What Is a Return on Investment?

A return on investment (ROI) is the profit or loss resulting from an investment transaction or a project, usually expressed as an annual percentage return. ROI is one of several approaches to building a financial business case. ROI means that decision makers evaluate the investment by comparing the magnitude and timing of expected gains to the investment costs.

Part of the decision makers’ responsibilities is to look for ways to improve ROI by reducing costs, increasing gains, or accelerating gains. The basic ROI can be found by dividing a company’s  net profit  or net earnings by the total investment, and multiplying by 100 to arrive at a percentage:

(Net profit / total investment) × 100 = Return on Investment

A more complex variation of ROI is a formula known as the Du Pont formula, which allows a company to break down its ROI into a profit-on-sales component and an asset-efficiency component. This formula is:

(Net profit after taxes / total assets) = (net profit after taxes / sales) × sales / total assets

A more investor-friendly formula for ROI is net income divided by common stock and preference stock equity, plus long-term debt. It is important to understand what a return on investment measures. Without this understanding, comparisons may be misleading. A search for “return on investment” on the Internet will produce sites detailing staff training, e-commerce, advertising and promotions. Be sure to establish whether the net profit figure used is before or after provision for taxes. This is important for making accurate comparisons of Return on Investment.

There are various ways to calculate ROI, so make sure you understand the different calculations when comparing companies or sections within a company. For more information on Return on Investment or ROI visit www.sharpeinvesting.com.