1. What is Return on Investment?
Every investment has its purpose. Most of us invest in return for something in addition to the amount we spent. One can gauge the efficiency of investment by checking the potential gains. This will help you in deciding whether to invest or not in a particular avenue. You can also check the ROI history to understand the performance trend of the scheme.
The performance of the scheme is considered excellent if it delivers the promised returns or more. Return on investment or ROI, for this reason, is significant for both fixed-income investments such as PPF or FD and equity-based investment tools like equity funds. ROI, therefore, is a comparison metric which can help you understand the return factor of investment and optimise your financial portfolio accordingly.
2. How to calculate ROI
Return on investment is generally calculated as total earnings divided by the actual investment cost. The bigger the ratio, the higher the gains accrued.
In the formula explained in the above image, ‘investment gains’ means the amount earned after redeeming or selling the investment. Remember, ROI is estimated in percentage – this makes it easier for investors to compare it with others.
ROI calculation with an example
Say, you made a lump sum investment of Rs.50,000 in an equity fund. After a maturity period of three years, you redeem the scheme and the amount credited to you is Rs.75,000. So, ROI as per the formula can be calculated as follows:
ROI = (75,000 – 50,000) / (50,000) = 1/2 or 50%
3. How to use ROI
You must have seen people using the words return and profit interchangeably. But they may not mean the same all the time. Return on investment only touch the money you capitalise in a scheme, mutual fund or a company, and the return you make on that amount based on the profit of the complete scheme, fund or company. Hence, do not think that ROI is the same as the return you make on your equity. Only in single ownerships does equity mean the overall assets of the company.
There are various methods to determine the ROI to assess profitability. A few conventional techniques are given below.
- Divide your net income (after all deductions from the total income), interest, and taxes by the overall costs and liabilities. This will help you gauge your income rate in comparison to the capital invested.
- Divide your net income and income taxes by proprietary equity and other liabilities to generate an income rate on invested money.
- Divide net earnings by total investments plus reserves to estimate the income rate on proprietary (ownership), equity and stock equity.
4. Benefits and limitations of ROI
|User-friendly: It is easy to calculate and you just need to know the cost and profit earned. You do not need the help of a financial expert to understand this.
||Ignores time value of money:
Different schemes have different tenures and maturity periods. So, a 50% ROI for a 1-year FD and the same for a 5-year ELSS cannot be comparable. Rate of return scores here as a performance metric.
|Globally understood: The formula is used across the world. It is simple enough to interpret and explain it to people.
||ROI doesn’t take inflation into consideration: It also doesn’t count additional costs like processing fee, stamp duty etc.
|Versatile: ROI formula has many applications like understanding profitability of a scheme and doing a comparative analysis among others.
||ROI results are easy to manipulate: So results can change from investor to investor. Use the same inputs to get an exact value.
5. How ROI continues to evolve
In recent times, many investors and enterprises are looking at a new way of calculating ROI – it is called Social Return on Investment. Aside from capital and profit, this SROI also considers socio-environmental factors. This ensures even more accuracy as they use extra-financial value. If you are an investor with ClearTax Invest, be assured that our experts use both ROI and SROI to handpick best performing schemes from top fund houses. Looking for a way to fulfil your short-term or long-term financial goals? Click on the CTA below.