How can return on investment (ROI) calculations be manipulated?

By Jean Folger AAA
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 compound annual growth rate (CAGR) in Excel?

    The concept of CAGR is relatively straightforward and requires only three primary inputs: an investments beginning value, ...
  2. What is the formula for calculating the debt-to-equity ratio?

    Find out how to use this fundamental financial ratio to help assess a company's performance.
  3. What are some common traits of undervalued stocks?

    There are a few basic factors found in companies that are worth more than their current stock price.
  4. What are the best indicators for evaluating technology stocks?

    Technology stocks are often some of the most discussed stocks on the news. How can investors spot the company that will roll ...
RELATED TERMS
  1. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  2. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...
  3. Working Capital

    This ratio indicates whether a company has enough short term ...
  4. Amortization

    1. The paying off of debt in regular installments over a period ...
  5. Net Present Value - NPV

    The difference between the present value of cash inflows and ...
  6. Total Debt-to-Capitalization Ratio

    An indicator that measures the total amount of debt in a company’s ...
comments powered by Disqus
Related Articles
  1. Balance Sheet: Analyzing Owners' Equity
    Fundamental Analysis

    Balance Sheet: Analyzing Owners' Equity

  2. Reading The Balance Sheet
    Investing Basics

    Reading The Balance Sheet

  3. What Is Opportunity Cost And Why Does ...
    Economics

    What Is Opportunity Cost And Why Does ...

  4. Analyzing A Bank's Financial Statements
    Fundamental Analysis

    Analyzing A Bank's Financial Statements

  5. How To Efficiently Read An Annual Report
    Markets

    How To Efficiently Read An Annual Report

Trading Center