In order to make an educated decision when making any investment, you need to try to determine how much you could make on that investment. It’s also important to know how much you’ve made on the investments you already have. To do this, you need to calculate return on investment, or ROI.
ROI measures the profit you will derive from an investment as a percentage of the cost of the investment. It is calculated by dividing the profit by the purchase price of an investment, then multiplying by 100 to get the percentage return. So: ROI = profit / cost of investment x 100.
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This applies to any investment that is made by a company or by an individual. You can calculate ROI on a stock purchase, on the acquisition of a company or on anything else that you buy with the intention of selling at a later date. You can calculate the actual ROI of an investment you made in the past and will sell today, or you can estimate the ROI of an investment you make today and expect to sell in the future.
Here’s what you need to know in order to calculate return on investment.
The Formula to Calculate Return on Investment (ROI)
Return on investment is the ratio of the purchase price to the difference between the purchase price and the selling price. Even though it is a ratio, it is usually expressed as a percentage.
To calculate ROI, you need to know the price that was paid for the investment and the price the investment will be sold for. To determine the net return on the investment, you subtract the purchase price of the investment from its selling price. This gives you the amount of profit you made on the investment. Divide the profit by the purchase price of the investment, then multiply that by 100% to get the percentage return on investment.
ROI Formula
ROI = profit / cost of investment x 100%
Examples of ROI
Here are some examples of ROI calculation.
Positive Example
An investor bought 100 shares of ABC Company stock on Jan. 1, 2020, for $100 per share. Their total investment was $10,000. On June 30, 2022, they sold those shares for $12,500, netting $2,500 on the sale — $12,500 selling price – $10,000 initial purchase price = $2,500 profit. Here’s how the investor calculated their ROI:
ROI = profit / cost of investment x 100%
ROI = $2,500 profit / $10,000 cost of investment x 100%
ROI = 0.25 x 100% = 25% ROI
This investment returned 25% in two and a half years.
Negative Example
Return on investment is not always positive. Here’s an example of negative ROI.
An investor bought 100 shares of XYZ Company stock on Jan. 1, 2020, for $100 per share, for a total investment of $10,000. On June 30, 2022, XYZ stock was trading at $60 per share. The investor sold the shares, taking a loss of $4,000 — $6,000 selling price – $10,000 initial purchase price = -$4,000.
Here’s the ROI calculation for this investment:
ROI = -$4,000 loss / $10,000 cost of investment x 100%
ROI = -0.40 x 100% = -40% ROI
This investment had a negative 40% ROI in two and a half years.
Return on Investment and Time
The basic ROI calculation does not consider the amount of time the investment is held. If you only look strictly at the ROI calculation, you may think you’re better off holding an investment for 10 years because it will return 10% over that time, rather than holding an investment for two years that returns 8% over that time. Clearly, making 8% in two years is better than making 10% in 10 years.
To factor this in, you can calculate annualized return on investment. This just means that you divide the ROI by the number of years you held the investment. In the above example of ABC Company stock that returned 25% over two and a half years, the annualized ROI would be 10% — 25% / 2.5 years = 10%.
Don’t Forget the Other Costs
When calculating ROI, you need to be sure to factor in any other costs associated with the investment in addition to the purchase price. For example, if you buy shares of stock and you pay your stockbroker a commission, you will need to add that commission to the purchase price before you subtract the selling price to get your profit. Remember that you may pay commission when selling a stock as well, so add that in too.
Be sure to include any costs you incurred as a result of the investment to get a true picture of your return on investment. Suppose you purchased an antique car as an investment for $10,000. You made some repairs and replaced some parts on the car, and you spent a total of $7,500. You also paid $2,500 to store the car in a garage so it wouldn’t be impacted by weather. The total cost of your investment in the car is $20,000. If you then sell the car for $50,000, your ROI is 150%.
Cost of investment = $10,000 purchase price + $7,500 repairs + $2,500 storage = $20,000
Net return on investment = $50,000 selling price – $20,000 cost = $30,000 return
ROI = $30,000 return / $20,000 cost x 100 = 150%
The ROI on this antique car is 150%.
Using ROI to Compare Future Investments
Calculating ROI on an investment when you know the purchase price and the selling price is a simple exercise. But using ROI to evaluate two or more different investment opportunities can be a little trickier. To do this, you’ll need to make some assumptions about the selling price of the investment you are considering.
Suppose you are comparing two different stocks and want to calculate the ROI for each to determine which is the better investment. You plan to invest $10,000.
Company A
DEF Company is a consumer products company that has been around for years. The stock is currently trading at $100 per share, so you will buy 100 shares. You expect that in five years it will be trading at $150 per share. If that’s true, your ROI will be:
Return = $15,000 position value in five years – $10,000 purchase price = $5,000
ROI = $5,000 / $10,000 x 100% = 50%
Since you are holding the stock for five years, your annualized ROI is 10%.
Company B
UVX Company is a startup company with big plans. Its stock is currently trading at $20 per share, so you will buy 500 shares. You expect that, within ten years, it will be trading at $100 per share. If that happens, your ROI will be:
Return = $50,000 position value in ten years – $10,000 purchase price = $40,000
ROI = $40,000 / $10,000 x 100% = 400%
Since you are holding this investment for ten years, your annualized ROI is 40%.
Comparison
Using this analysis, UVX is a better investment. But ROI only tells part of the story.
If DEF Company stock takes off and reaches $150 per share in a year, your annualized ROI would be 50%, which would make that a better investment than UVX. In addition, UVX is a new company without a proven track record, so purchasing its stock could be riskier. If, however, UVX exceeds expectations and gets to $100 per share in five years, you’re sitting pretty with an 80% annualized ROI.
Using ROI To Determine When To Sell
Using expected return on investment to determine which investments to buy is part science and part art. But using it to determine which investments to sell is just science.
When it’s time to make changes to your portfolio, comparing the ROI on different investments can often tell you which ones to keep and which ones to sell. If you have an investment that has consistently produced solid annualized ROI, it’s probably worth keeping. Those with lower ROI, or even negative return on investment, may be good candidates to sell. Again, be sure to take other factors into account as well, as ROI doesn’t tell you everything.
Takeaway
In order to be a successful investor, you need to be able to measure that success. Knowing the return on investment you’ve achieved from each of the investments you’ve made is a good way to do that.
This article originally appeared on GOBankingRates.com: How To Calculate Return on Investment (ROI)
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
