Return on Investment – Kevin McKinney

March 3, 2011

How do you know if a business deal or investment is worth your time and most importantly your money? The answer to this question can be answered by calculating and understanding the meaning behind expecting a “return on investment”. Return on Investment (ROI) (also referred to as Rate of Return (ROR)) (3) gives you the percentage of gain you have received or expect to realize on a given investment.

ROI can be defined as the following: “ A measure of a corporation’s profitability, equal to a fiscal year’s income divided by common stock and preferred stock equity plus long-term debt “(1). For those of us that are not bankers or accountants a simpler definition would be: The percentage of money that has or will be made on a given investment.

The website Investopedia states the return on investment formula as:

ROI=(Gain from Investment – Cost of Investment)/Cost of Investment (2)

In the above calculation, if the number generated is positive you made money. For example if the above calculation gave you a solution of .25, you would state that you made a 25% return on your investment.

In the last few decades, ROI has become a central financial metric for asset purchase decisions (computer systems, factory machines, or service vehicles, for example), approval and funding decisions for projects and programs of all kinds (such as marketing programs, recruiting programs, and training programs), and more traditional investment decisions (such as the management of stock portfolios or the use of venture capital) (4).

The wonderful thing about ROI is the ability to calculate accurate percentages on expected profits from different investments. Let’s look at a fictional example:

Rob has recently filed his taxes and expects to get an even $1000.00 back. Being a wise individual, Rob decides to let his money work for him. Rob talks with Jill about two different investment opportunities.

Investment A: The first investment requires Rob to invest $500 upfront and another $500 in 6 months. This investment is expected to give Rob $92.50 per month.

Investment B: The second investment requires Rob to initially invest $900 upfront, leaving Rob $100 left over. This investment is expected to give Rob $85 per month.

Rob is quickly able to work these calculations and determine which investment is right for him. After performing the calculations Rob is able to see that Investment B is the better investment giving him a 13.33% return on his investment while investment A only gives him a return of 11%.

The above example illustrates the power behind using ROI as a financial tool. It is easy to see that with different initial investment amounts which investment is the better choice.

A very important thing to note about ROI calculations is that the formula can and will be modified by the individual giving the statistic. Always make sure you understand how they reached this number because depending on what values are used you can receive different results. This goes double if time is involved within the calculation.

A word to the wise; ROI calculations are not guarantees unless the calculation is done after the investment has matured. Be very cautious about performing a single calculation when doing your comparisons. Make sure, as an investor or business owner that you calculate your ROI at different investment and return amounts to guard against investments not living up the potential they promise.

As you can see calculating the Return on Investment for individuals and businesses can prove to be a very profitable and wise decision. Given the ability to compare opportunities and measure different investments side by side allows you to make the most informed and educated investment decision. Just remember that little phrase your grandparents said to you when you where younger, “If it is too good to be true, it probably is”.

References

1) Investorwords – Return on Investment (http://www.investorwords.com/4250/Return_on_Investment.html)

2) Investopedia – Return on Investment – ROI (http://www.investopedia.com/terms/r/returnoninvestment.asp)

3) Wikipedia – Rate of return (http://en.wikipedia.org/wiki/Return_on_Investment)

4) Solution Matrix – Return on Investment: What is ROI analysis? (http://www.solutionmatrix.com/return-on-investment.html)

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2 Responses to “Return on Investment – Kevin McKinney”

  1. Jason Chuang said

    This was a very good topic to be aware of when doing your own business. You will need to know your ROI if you are able to continue or your business or it will fold over time.

  2. I say just buy it. What is the worst thing that can happen? Well, nay sayers can make the numbers look anyway they desire. You have to watch out for the payback analysis mote dragons!

    http://trentrichardson.wordpress.com/2009/09/10/beware-of-the-payback-analysis-mote-dragons/

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