Understand ROI (Return on Investment)
ROI
helps you understand how much profit or loss your investment has earned when
you put money into an investment or a business endeavour. ROI is a simple ratio
that is calculated by dividing the net profit (or loss) from an investment by
its cost. Using ROI you can compare the effectiveness or profitability of
different investment choices. It helps you to analyse how much you paid for an
investment to how much you earned to evaluate its efficiency. Let’s take a brief
look.
ROI
is an understandable and easily calculated metric. Using ROI start evaluating your
investment, but do not stop your investment there.
Understanding Return
Calculating
return would be easier if you are investing more than for a one year. If your investment
duration is lesser than one year, then by assuming that the investment is
held for one year you can calculate the return in percentage terms. But that
doesn’t happen in practical world. Investment is normally done in staggered
manner. Each investment is not kept for same period of time some may be long
term and some may be for short term. You can withdrawal money over a certain period
of time.
If
you want to know or compare the investment return from various investment
plans, it is necessary to have a common parameter which can be used for all
types of investments with different investment amounts as well as different
holding period.
1. CAGR – Compounded
Annual Growth Rate
CAGR (Compounded
Annual Growth Rate) is used to calculate the return for one time investment.
But if the investment is done periodically or staggered over a certain period
of time, than don’t use CAGR to calculate the return.
2. IRR – Internal
Rate of Return
IRR
is used in case of staggered investment. If the investment is done in a strict
periodic manner like monthly, quarterly or yearly, you can use IRR to calculate
the rate of return.
3. XIRR
XIRR
is used for calculating the rate of return if cash flow includes frequent
inflow as well as outflow over a period of time. XIRR gives you the flexibility
to allocate one specific date for each cash flow. As we all know that return
is one of the most important criteria but along with this we should also look
at other parameters like consistency, portfolio quality, risk, risk adjusted
returns etc.
How to Use ROI?
Regular
investors use ROI to evaluate their portfolios. It helps you to judge or
analyse almost any type of expenditure. A business owner can use ROI to
calculate the return on the cost of advertising.
Remember
that ROI is only as good as the numbers you feed into your calculation because
ROI cannot eliminate risk or uncertainty. Even after using ROI calculator to
decide your future investments, still you need to factor in the risk that your
projections of net profits can be too optimistic or too pessimistic. And, one
thing to remember that with all your investments, historical performance is no
guarantee of future success.
How to Calculate ROI?
To
calculate return on investment or net profit, divide the amount you earned from
an investment and multiply by 100. Or you can calculate the cost of the
investment minus its present value—by the cost of the investment and multiply
that by 100. The outcome result should be represented in percentage. Below are
the two ways to represent ROI formula:
ROI
= (Net Profit / Cost of Investment) x 100
ROI
= (Present Value – Cost of Investment / Cost of Investment) x 100
The
percentage outcome helps you to compare it to the ROI percentage of other investments.
It helps you to determine which investment gives the highest yield.
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