Return on investment is a measurement designed to evaluate the ability of an investment to generate income. The ratio is used to compare alternative investment choices, as well as to determine if an existing investment represents an efficient use of resources. This is one of the most popular investor measurements, given the easy availability of the required information and the simplicity of the formula.
The calculation of the return on investment is a two-step process, which is as follows:
- Subtract the cost of an investment from its current value (which could be its sale price)
- Divide the result by the cost of the investment
Thus, the return on investment formula is:
(Current value of investment – Cost of investment) / Cost of investment
A variation on the formula that applies more to corporate decision making is to divide net income by invested assets.
The formula is:
Net after-tax income / Total assets invested
The measurement can be used for multiple types of decisions, such as the following:
- Purchase or sale of shares. An investor can use it to either estimate the future return on a prospective stock purchase, or to tally up the actual return at the time when the investor sells shares to a third party.
- Capital budgeting. The management team can use it to judge among different uses to which an investment fund can be put.
- Program approval. The management team can use return on investment as one of its criteria before authorizing expenditures on a variety of programs, such as employee training or a marketing campaign.
The main drawback when using the return on investment is that it does not contain a risk component. That is, there is no indication of the probability that a return will actually be generated in the expected amount.