A:

Return on Investment (ROI) is a performance metric used to evaluate the financial efficiency of an investment, or to compare the relative efficiency of multiple investments. It measures an investment’s gain or loss relative to the initial investment. ROI is calculated as follows:

ROI = (earnings – cost of investment) / cost of investment * 100%

ROI typically appears as a percentage; for example, investment XYZ has a ROI of 10%. The ROI calculation is the same for every type of investment – whether it’s stocks, real estate, or collectibles. The calculation can be manipulated, however, in terms of how costs and returns are accounted for. For example, real estate investors can use either the cost method or the out-of-pocket method to determine ROI.

Assume a real estate investor buys a house for $150,000, puts $50,000 into it for repairs and renovations, and then sells the property for $250,000. The investor’s equity position in the property is $250,000 – ($150,000 + $50,000) = $50,000. If the investor uses the cost method, the ROI will be calculated by dividing the equity by all costs:

$50,000 / $200,000 *100% = 25% ROI

If the investor instead uses the out-of-pocket method, the ROI will be calculated taking into consideration the down payment amount instead of the purchase price. A 20% down payment on the $150,000 property would be equal to $30,000, and total costs would be limited to this down payment plus the $50,000 for repairs and renovations, or $80,000 total. With the value of the property at $250,000, the investor’s equity position in the property would be $250,000 – ($30,000 + $50,000) = $170,000. The ROI again is calculated by dividing the equity by all costs:

$170,000 / $80,000 *100% = 212% ROI

As the example shows, the ROI for similar investments can vary greatly, depending on how the value is calculated. In these examples, the out-of-pocket method allows the investor to use leverage (by financing the property) to increase the ROI. It would be important, however, to take into consideration the costs associated with the loan, as they will affect the bottom line. It’s also important to stick to one method if more than one investment is being evaluated; otherwise, the results will be misleading.

RELATED FAQS
  1. What is the formula for calculating the debt-to-equity ratio?

    Expressed as a percentage, the debt-to-equity ratio shows the proportion of equity and debt a firm is using to finance its ... Read Full Answer >>
  2. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
  3. How can the price-to-earnings (P/E) ratio mislead investors?

    The price-to-earnings (P/E) ratio is calculated by dividing a company’s stock price per share by its earnings per share (EPS), ... Read Full Answer >>
  4. Is there value in comparing companies from different sectors by using the debt-to-equity ...

    The debt-to-equity ratio is a measure of a company's financial leverage that relates the amount of a firms' debt financing ... Read Full Answer >>
  5. What is considered a high debt-to-equity ratio and what does it say about the company?

    The debt-to-equity ratio is a measure of a company's financial leverage that relates the amount of a firms' debt financing ... Read Full Answer >>
  6. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: iShares Morningstar Small-Cap Value

    Find out about the Shares Morningstar Small-Cap Value ETF, and learn detailed information about this exchange-traded fund that focuses on small-cap equities.
  2. Investing

    How To Calculate Minority Interest

    Minority interest calculations require the use of minority shareholders’ percentage ownership of a subsidiary, after controlling interest is acquired.
  3. Mutual Funds & ETFs

    ETF Analysis: WisdomTree SmallCap Earnings

    Discover the WisdomTree Small Cap Earnings ETF, a fund with a special focus on small-cap and micro-cap stocks with positive earnings.
  4. Mutual Funds & ETFs

    ETF Analysis: iShares US Regional Banks

    Obtain information and analysis of the iShares US Regional Banks ETF for investors seeking particular exposure to regional bank stocks.
  5. Technical Indicators

    Key Financial Ratios to Analyze the Mining Industry

    Discover some the most important financial ratios used by investors and analysts to evaluate companies in the metals and mining industry.
  6. Technical Indicators

    Key Financial Ratios to Analyze Retail Banks

    Learn about key financial metrics that investors use to evaluate retail banks, and how the industry is fundamentally different from most other industries.
  7. Technical Indicators

    Key Financial Ratios to Analyze Airline Companies

    Examine some of the most important financial ratios and performance metrics investors use to evaluate companies in the airline industry.
  8. Stock Analysis

    The 5 Biggest Canadian Oil Companies

    Obtain information about some of the largest and most successful major integrated oil corporations that are headquartered in Canada.
  9. Technical Indicators

    Key Financial Ratios to Analyze Tech Companies

    Understand the technology industry and the companies that operate in it. Learn about the key financial ratios used to analyze tech companies.
  10. Stock Analysis

    3 Reasons to Continue to Own Monster Beverage

    Learn more about the Monster Beverage Corporation and some of the primary reasons why investors and market analysts like the stock.
RELATED TERMS
  1. Balance Sheet

    A financial statement that summarizes a company's assets, liabilities ...
  2. Equity

    The value of an asset less the value of all liabilities on that ...
  3. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  4. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  5. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  6. Current Assets

    A balance sheet account that represents the value of all assets ...

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!