Return on Investment (ROI)

What is a Good ROI Ratio?

The return on investment (ROI) is a widespread financial metric due to its simplicity, since only two inputs are necessary to calculate the ROI ratio.

1. Net Return
2. Cost of Investment

However, one drawback is that the “time value of money” is neglected, i.e. a dollar received today in worth more than a dollar received in the future.

If there are two investments with the same return, yet the second investment requires twice the amount of time until it is realized, the ROI metric on its own fails to capture this important distinction.

Therefore, when making comparisons among different investments, investors must ensure the time frame is the same (or nearby) or otherwise remain cognizant of the timing discrepancies between investments when putting together rankings.

One variation of the metric is called the annualized return on investment, which adjusts the metric for differences in timing.

Furthermore, a common mistake in calculating the metric is neglecting side expenses, which tends to be more applicable to projects in corporate finance.

The ROI calculation must factor in each and every profit and incurred cost associated with the project (e.g. unexpected maintenance fees) and investments (e.g. dividends, interest).

ROI Calculator | Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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1. ROI Calculation Example

Suppose an industrial company spent $50 million in capital expenditures (Capex) to invest in new machinery and upgrade their factory.

By the end of the anticipated holding period – which in the context of a company purchasing fixed assets is the end of the PP&E’s useful life assumption – the company received $75 million.

The net return on the PP&E investment is equal to the gross return minus the cost of investment.

• Net Return = $75m – $50m = $25m

The net return of $25 million is then divided by the cost of investment to arrive at the return on investment (ROI).

• Return on Investment (ROI) = $25m ÷ $50m = 50%

Given the $50 million net return and $25 million cost of investment, the ROI is 50%, as shown in the screenshot below.

2. Equity Investment ROI Ratio Analysis

In the next example scenario, a hedge fund has purchased shares in a publicly-traded company.

On the date of the purchase, the company was trading at $10.00 and the hedge fund bought a total of 4 million shares.

Thus, the cost of investment to the hedge fund comes out to $40 million.

• Cost of Investment = $10.00 × 4m = $40m

Five years from the date of purchase, the hedge fund exits the investment – i.e. liquidates its position – when the shares are up 20% relative to the entry share price at $12.00 per share.

If we assume that 100% of their equity stake is sold, the total proceeds post-sale are $48 million.

• Total Proceeds from Sale = $12.00 × 4m = $48m

The net return comes out to $8m, which is the difference between the total proceeds from the sale ($48m) and the cost of investment ($40m).

The ROI on the hedge fund’s investment is therefore 20%.

Since we are given the holding period of the hedge fund in this particular investment (i.e. 5 years), the annualized ROI can also be calculated.

To calculate the annualized ROI, we’ll use the “RATE” function in Excel to determine the ratio as 3.7%.

Alternatively, we could have divided the total sale proceeds by the cost of investment, raised it to the power of (1/5), and subtracted 1 – which also comes out to 3.7%, confirming our earlier calculation is correct.