Return On Investment Wikipédia

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Return on Investment (ROI) Explained

Return on Investment (ROI) is a widely used financial metric to evaluate the efficiency or profitability of an investment. In simple terms, it measures how much money you gain or lose relative to the amount of money you invested. A higher ROI indicates a more profitable investment.

Calculation

The basic formula for ROI is:

ROI = (Net Profit / Cost of Investment) x 100

Where:

Net Profit is the revenue generated from the investment, minus the initial cost.
Cost of Investment is the initial amount of money spent on the investment.

The result is expressed as a percentage. For example, an ROI of 20% means that for every dollar invested, the investment generated a profit of 20 cents.

What ROI Tells You

ROI is valuable because it’s easy to calculate and understand, providing a quick snapshot of an investment’s performance. It allows for comparison between different investments, helping investors make informed decisions about where to allocate their capital. ROI can be used to evaluate past investments, forecast potential returns, or compare the performance of different assets within a portfolio.

Limitations of ROI

Despite its simplicity, ROI has limitations:

Time Value of Money: ROI doesn’t consider the time value of money. A dollar earned today is worth more than a dollar earned in the future due to inflation and the potential for earning interest. More sophisticated metrics like Net Present Value (NPV) address this.
Risk: ROI doesn’t factor in the risk associated with an investment. A high-ROI investment may be riskier than a low-ROI investment.
Single Period Metric: Standard ROI calculations typically assess performance over a single period (e.g., a year). They don’t account for long-term impacts or ongoing costs and benefits beyond that period.
Potential for Manipulation: ROI can be manipulated by adjusting the timing of revenue recognition or delaying expenses.
Difficulty in Comparison Across Industries: Comparing ROIs across vastly different industries can be misleading due to varying capital structures and accounting practices.

Beyond the Basic Formula

Variations of the basic ROI formula exist to address some of its limitations. For instance, annualized ROI calculates the average annual return for investments held over multiple years. Internal Rate of Return (IRR) is another metric that considers the time value of money and calculates the discount rate at which the net present value of all cash flows from a project equals zero.

Conclusion

ROI is a useful tool for evaluating investment performance but should not be the sole basis for decision-making. It’s important to understand its limitations and consider other financial metrics and qualitative factors, such as risk, market conditions, and strategic alignment, to make well-informed investment choices.

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