ROI Explained: Meaning, Formula, Examples & Key Limitations

ROI is the commonly used measure to judge whether an investment is worth the money put into it. From stocks and real estate to marketing campaigns and new machinery, ROI helps investors and businesses compare outcomes in simple percentage terms. However, while ROI is easy to calculate and understand, it is often misunderstood and sometimes misused. This article explains what ROI means, how it is calculated, where it works best.

What is ROI ( Return on Investment)?

ROI refers to Return on Investment. It shows how much profit or loss you make from an investment compared to the money you put in. It helps you judge if an investment is profitable. You can calculate ROI by dividing the profit earned by the total investment cost. The output is expressed as a percentage. 

A higher ROI suggests better returns, which you can use to allocate capital more effectively, thereby reducing investment risk. ROI is generally used to compare investment options, such as stocks, businesses, or small- and large-scale projects.

To compute ROI, use the following ROI formula:

ROI (%) = (Net Profit ÷ Cost of Investment) × 100

Examples of ROI Calculation

Here are the examples of ROI calculation from different sectors:

Stock Investment ROI

Suppose you invest ₹1,00,000 in the stock of a company. After a year, you sell the stock for ₹1,20,000. 

To calculate ROI, subtract the initial investment from the final value, and you will get ₹20,000 (₹1,20,000 − ₹1,00,000). Now divide this amount by the initial investment: ₹20,000 ÷ ₹1,00,000 = 0.2. Next, multiply by 100 to get a percentage. 

The ROI is 20%. This means your stock investment earned a 20% return over the year.

Real Estate Investment ROI

Suppose you invested ₹50,00,000 in a rental property. You earned ₹3,00,000 in rental income in the first year. You have also spent ₹50,000 on maintenance. The net profit you are left with is ₹2,50,000 (₹3,00,000 − ₹50,000).

To calculate ROI, divide the net profit by the initial investment: ₹2,50,000 ÷ ₹50,00,000 = 0.05. Multiply the output by 100. The ROI for this property will be 5%.

Business Marketing Campaign ROI

A company spent ₹2,00,000 on a digital marketing campaign due to which it earned an extra ₹3,50,000 in sales. The profit by subtracting the cost from the revenue is ₹1,50,000 (₹3,50,000 − ₹2,00,000).

Now, calculate ROI by dividing the profit by the amount spent:

₹1,50,000 ÷ ₹2,00,000 = 0.75.

Multiply by 100 to convert it into a percentage.

0.75 × 100 = 75%.

This means the marketing campaign gave a 75% return. In simple words, for every ₹1 spent, the company earned ₹1.75 in revenue.

Alternatives to ROI

Other metrics that are common alongside ROI are:

Internal Rate of Return (IRR)

IRR represents the annualised rate of return at which the net present value (NPV) of all future cash flows becomes zero. In simple terms, IRR tells you the expected growth rate of your investment, assuming all cash flows are reinvested at the same rate.

IRR Formula

The IRR is calculated using the NPV equation:

NPV = 0 = −C₀ + C₁/(1 + IRR)¹ + C₂/(1 + IRR)² + … + Cₙ/(1 + IRR)ⁿ

Here,

• C₀ is your initial investment (cash outflow),
• C₁, C₂, …, Cₙ, are the cash inflows in future periods, and
• n is the number of periods.

Since IRR appears in the exponent, you cannot calculate it directly using simple algebra. It is recommended to use trial-and-error, financial calculators, or spreadsheet functions such as Excel’s IRR().

Suppose you invest ₹1,00,000 in a project today. You expect to receive ₹40,000 from it at the end of each year for three consecutive years. The cashflow will be as follows:

• Initial investment (Year 0): −₹1,00,000
• Year 1 inflow: ₹40,000
• Year 2 inflow: ₹40,000
• Year 3 inflow: ₹40,000

Try different discount rates to see at what rate the NPV becomes zero.

• At 10%, the NPV is positive, that means returns exceed 10%.
• At 15%, the NPV is close to zero

This indicates that your IRR is approximately 15%, meaning your investment generates an annual return of about 15%.

You can use IRR to compare investment opportunities. If the IRR is higher than your required rate of return or cost of capital, the investment is considered attractive.

Net Present Value (NPV)

Net Present Value (NPV) is a simple way to check whether an investment is worth doing. It compares the money you invest today with the money you expect to receive in the future. Because money today is more valuable than money later, future cash flows are reduced using a chosen interest rate. If the total value of future cash inflows exceeds the initial investment, the NPV is positive.

Use the following formula to calculate NPV:

NPV = Σ [Cash Flowₜ ÷ (1 + r)ᵗ] − Initial Investment

Here,

• ‘r’ is the discount rate (your required rate of return)
• ‘t’ is the time period

Suppose a project you wish to invest in needs an upfront investment of ₹1,00,000. It is projected to give a 10% return of ₹40,000 each year for 3 years.

To compute NPV, discount the annual cash flows to their present values:

• Year 1: ₹40,000 ÷ (1.10)¹ = ₹36,364
• Year 2: ₹40,000 ÷ (1.10)² = ₹33,058
• Year 3: ₹40,000 ÷ (1.10)³ = ₹30,053

Next, add these present values, and you will get around ₹99,475.

Finally, subtract the initial investment:

NPV = ₹99,475 − ₹1,00,000 = −₹525

Here, the NPV is slightly negative. The project does not meet your 10% return expectation.

Return on Equity (ROE)

ROE shows how much profit a company earns for every rupee its equity shareholders invest in. Simply put, ROE measures the return you receive on the company’s net worth.

To calculate ROE, use the following formula:

ROE = (Net Profit ÷ Shareholders’ Equity) × 100

Here,

• Net profit refers to the profit after tax earned during a financial year
• Shareholders’ equity includes equity share capital plus reserves and surplus, minus accumulated losses, if any

Suppose you are analysing a company that reports a net profit of ₹20 crore for the year. As per the balance sheet, shareholders’ equity is ₹100 crore.

Putting the values in the formula:

ROE = (₹20 crore ÷ ₹100 crore) × 100

ROE = 20%

This means for every ₹100 of shareholders’ funds, the company earns ₹20 as profit during the year.

Why is ROI Important?

Here is what relevance ROI holds:

• ROI helps you clearly measure how well an investment performs by comparing net gains with the amount invested. You can quickly see whether the returns justify the capital committed.
• When you have multiple investment options, ROI helps you choose objectively instead of relying on assumptions.
• ROI validates whether your investment strategy is working as intended. You can track outcomes against expectations and determine if strategic assumptions were accurate.

How to Improve ROI?

If you are an investor looking to improve the ROI of your investment, follow the tips below:

• Spread your investments across multiple asset classes.
• Regularly track the performance of each investment. When you monitor regularly, you can act quickly, optimise profits, and avoid prolonged losses.
• Instead of withdrawing dividends or interest, reinvest them in your investments. Compounding increases your capital base, which magnifies returns over time.
• Define clear and measurable financial objectives. Knowing your target ROI or income requirement guides asset selection and strategy.
• Avoid making investment decisions based on fear, greed, or hype.
• Identify industries with strong growth potential and allocate capital accordingly.

Limitations of ROI

Here are some of the downsides of ROI:

• ROI does not consider the investment duration. You may see high returns, but without factoring in time, you cannot accurately compare short-term and long-term investments.
• ROI ignores investment risk. You may find two projects with the same ROI; however, their associated risks may differ.
• ROI focuses on profits, not cash flow timing. You might earn high ROI on paper, but with delayed or irregular cash inflows, liquidity challenges arise.
• ROI does not adjust for inflation. A high nominal ROI may not reflect real gains in purchasing power.
• ROI excludes hidden or indirect costs. Since it does not include management fees, taxes, or maintenance expenses, it not only reduces your actual gains.

Conclusion

ROI is the easiest way to determine whether an investment is profitable. However, considering its limitations, such as not factoring in time, cash flow, and inflation, it is recommended to use it along with other metrics such as IRR, NPV, and ROE. When you are aware of the investment’s potential, you can efficiently rebalance it based on current market trends and global events, so that your portfolio does not include any non-performing assets.