What is Return on Investment (ROI)?
Return on Investment (ROI) is a widely used financial metric used to evaluate the efficiency or profitability of an investment. It directly measures the amount of return on a particular investment relative to the investment's cost. To express ROI as a percentage (so it is easy to compare against other investments), the net profit is divided by the original capital cost, and then multiplied by 100.
The ROI Formula
The mathematical formula for calculating Return on Investment is simple:
For example, if you spent $1,000 on Facebook Ads and generated $2,500 in revenue, your Net Profit is $1,500. Divide $1,500 by the original $1,000 cost, and you get 1.5. Multiply by 100, and your ROI is 150%.
Limitations of ROI
While ROI is an excellent metric for comparing the raw profitability of different ventures, it has one major flaw: it does not account for time. A 20% ROI achieved over one week is vastly superior to a 20% ROI achieved over five years, but the basic formula treats them identically. For multi-year investments, metrics like Annualized Return or CAGR (Compound Annual Growth Rate) are often preferred.