Return on Investment

Return on Investment (ROI)

This measures the overall profit or loss on an invesment expressed as a percentage of the total amount invested or total funds appearing on a company's balance sheet.

Why it is important

Like ROA or ROE, ROI measures a company's profitability and its management's ability to generate profits from the funds investors have placed at their disposal.

One opinion holds that if a company's operations cannot generate net earnings at a rate that exceeds the cost of borrowing funds from financial markets, the future of that company is grim.

How it works in practice

The most basic expressio of ROI is:

ROI = net profit / total investment

A more complex variatio of ROI is an equation known as the Du Pont formula:

ROI (Du Pont formula )
= (net profit after taxes/total assets)
= (net profit after taxes/sales) x (sales/total assets)

Champions of this formula, which was developed by the Du Pont Company in the 1920s, say that it helps to reveal how a company has both deployed its assets and controlled its costs, and how it can achieve the same percentage return in different ways.

For shareholders, the variation of the basic ROI formula used by investors is:

ROI
= [net income + (current value - original value) / original value ] x 100

For example, somebody invests $5,000 in a company and a year later has earned $100 in dividends, while the value of the shares is $5,200, the return on investment would be:

ROI
= [100 + (5,200 - 5,000) / 5,000 ] x 100
= [(100+200)/5,000] x 100
= 6%

TRICKS OF THE TRADE

• Securities investors can use yet another ROI formula: net income divided by shares and preference share equity plus long-term debt.
  
  
• It is vital to understand exactly what a ROI measures, for example assets, equity, or sales. Without this understanding, comparisons may be misleading or suspect. A search for "return on investment" on the web, for example, harvests everything from staff training to e-commerce to advertising and promotions!
  
  
• Be sure to establish whether the net profit figure used is before or after provision for taxes. This is important for making ROI comparisons accurate.