How to Calculate Return on Investment (ROI)
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At its heart, calculating return on investment or ROI is a way to measure how well your investments are doing. It’s used by both businesses and individuals to decide where to invest their money (often referred to as capital.)
This post walks step-by-step through different ways to calculate return on investment to help you make more effective investment decisions.
Return on Investment (ROI) Definition
Return on investment is a specific measure of how much money an investment has made relative to the cost of that investment. In other words, it’s a quick way to see how well an investment is really doing.
For example, let’s say your tech startup collected $50,000 from in-app purchases last month. That might sound pretty good—unless it cost you $100,000 in advertising to make that happen.
That’s why the formula used to calculate return on investment includes both your profits and the investment it took to make those profits.
Return on Investment (ROI) Formula
The return on investment (ROI) formula can help you understand how much you’ve earned on an investment relative to its cost.
You can use the ROI formula to calculate ROIs on various types of investments, including stocks and bonds, and it can be helpful when you’re comparing two investments. You can also use it when reviewing your portfolio to understand which investments are performing better than others.
Here’s the return on investment formula:
ROI = (Current Value - Cost) / Cost
The first part (Current Value - Cost) tells you how much you made. If you invested $300 in a certain stock and now that stock is worth $360 (its current value), you made $60.
You divide that amount by the original investment ($300) to get your ROI.
ROI = ($360 - $300) / $300
ROI = $60 / $300
ROI = 0.2
You can multiply your ROI by 100 to see it as a percentage. In this case, 0.2 x 100 = 20%. So, if you bought a stock at $300 and it’s now worth $360, the ROI of that investment is 20%.
In the world of finance, determining the true ROI of complex investments can get much more detailed, and we’ll get into some more complicated examples below. Still, this simple calculation is a quick way to get at the heart of what ROI is trying to measure: how well an investment is doing for you.
Return on Investment (ROI) Calculator
You can use a return on investment calculator to calculate your ROI the easy way. In the calculator below, enter the amount you invested in the first box. Enter the number you end up with (the current value) in the second box.
In the example above, you’d enter $300 in the Amount Invested box for your investment and $360 in the Amount Returned box for the amount returned. If you try it, you’ll see that the return is expressed as a percentage. In this case, 20%.
The investment gain is also calculated for you (the top part of the return on investment formula). That’s provided at the bottom, labeled Investment Gain.
One thing that won’t tell you, though, is how long it took to make that return. ROI doesn’t take into account the amount of time that’s gone by.
Return on Investment (ROI) Examples
Return on investment is a critical tool for both individual investors and businesses in evaluating how well a given investment is doing. Here are just a few examples of how it can be used in real-world situations:
Investing in stocks
ROI is often used by investors to evaluate how well different stocks are doing. Investors compare the ROIs of those stocks to help them decide where to invest their money as they move forward.
Homeowners can also use ROI to evaluate home improvement projects. Major changes to a home, such as a new bathroom or the addition of a deck, often add to the home’s market value. Divide that additional value by the cost of the improvement to get the ROI of a specific project.
Companies often run advertisements to boost sales. To compare the effectiveness of different ads or campaigns, they calculate the ROI of each one.
Advertising often uses a slightly different calculation for ROI, simply dividing the income an ad generates by the cost of that ad. In that case, an ROI that’s higher than 1 means the ad is making money. For example, if an ad brought in $1,200 in revenue and it cost $1,000 to run, the ROI would be 1.2, or 120%.
You can also learn something about that ad’s effectiveness from the ROI itself, without knowing anything about the actual numbers. A reported ROI of 1.05, for example, would mean that for every $100 the company is spending, the ad is generating $105 in revenue.
On the other hand, an ROI that’s lower than 1 would mean the ad was losing money. A reported ROI of 0.95 or 95% would mean the ad was only bringing in $95 for every $100 spent.
If you’re using ROI in your business, remember that it’s not just one sale that matters but how many more sales you might make to that customer over a lifetime. Seen in this light, it’s obvious that something as “simple” as ROI can actually be a highly complex calculation!
How to Calculate Rate of Return (ROR)
Rate of return (ROR) is the same thing as return on investment (ROI), and you can use the same formula (or the same calculator above) to calculate it. The main difference is that people include the amount of time that’s gone by when thinking and talking about rate of return.
For example, in the stock example earlier, an investment of $300 that is now worth $360 has an ROI of 20%.
If it took the investment one year to grow from $300 to $360, the rate of return on that investment would be 20% per year. In fact, the usual assumption about ROR is that it means per year if it doesn’t specifically say something else.
It might not sound like there’s much of a difference between ROI ad ROR, but the time factor that ROR adds can make a big difference. An ROI of 20% is great if it took one year for your investment to grow by 20%. It’s not nearly as great if it took 10 years.
That’s why time periods are important when you’re considering new opportunities or revisiting long-term holdings. An investment with a 100% ROI (after five years) will earn you less money than an investment that maintains a 25% annual ROR over five years.
How to Calculate Total Return on Investment
Building on the ROI and ROR formula, you might sometimes need to add additional forms of income or expenses to calculate your total return from an investment. Some stocks pay out dividends, bonds could offer coupons, and you may have to pay brokerage fees for each trade.
The total return formula takes interest, dividends, capital gains, and expenses into account to help you understand your actual rate of return in a specific time period—again, generally over a year.
For a stock, the total return formula is:
Total Return = [(Current Value - Cost) + Dividends - Expenses]/Cost
For example, if a stock increased from $100 to $110 over a year and also paid you a $4 dividend, but there was a trade fee of $10 when you bought it, the equation is:
Total Return = [(110 - 100) + 4 - 10]/100 = 0.04
Or, 4% if you multiply by 100 to get the percentage total return.
Because the total return includes the income from an investment as well as the investment’s growth, this is a better way to compare investments that have different dividend rates. In fact, some people and companies use this more inclusive equation when calculating ROI and ROR, even if they don’t specifically refer to it as “total return.”
Total Return on Investment (ROI) Calculator
If you want to calculate the total return on a given investment, you can use the calculator below.
For the stock in the example above, the current value is $110 (what it’s worth now). The cost is $100 (what you paid for it originally). The dividends are $4, and the expenses are $10. If you enter those in the calculator, you’ll get a result of 4%.
How to Calculate Annualized Return on Investment (ROI)
If you’re holding an investment for multiple years, you may want to calculate your annualized return on investment (AROI). This tells you the average annual gains (or losses) from that investment, which you can then compare to a broad index to see if you “beat” the market. This is often called the annualized rate of return instead of an annualized ROI since it takes time into account.
The annualized ROI formula builds off the simple ROI equation:
AROI = [(1 + ROI)1/n - 1
The n represents the number of years you’ve held the investment. If it’s been less than a year, or part of a year, you can use a decimal. For example, 1/1.5 if you’ve held an investment for a year and a half.
Using the example investment from above, say you hold the stock for five years, its value increases to $175, and it pays out the $4 dividend five times. Here are the ROI and annualized ROI equations:
ROI = [(175 - 100) + (4 x 5) - 10]/100 = 0.85 or 85%
AROI = [(1 + 0.85)1/5 - 1 = 0.13 or 13%
As with the simple rate of return formula, you can use the AROI equation to compare your investments and see which ones are performing best.
Comparing Investments and Annualized Returns on Investment (ROI)
You can calculate the annualized return for a given stock or investment over any period of time. This has a lot of advantages when it comes to making investment decisions.
For one thing, you can easily compare the returns of stocks you’ve owned for different amounts of time. Annualize the returns of those stocks to compare their performance in a meaningful way.
You can also annualize returns over longer periods of time to “even out” the normal fluctuations of the stock market. Use several years’ worth of history to find the annualized rate of return of a stock over the past 5 or 10 years. How did a stock do this past year compared to its historical rate of return? You can find that out too.
You can even annualize returns to compare entirely different kinds of investments. For example, should you put more money into that mutual fund or put it into your investment real estate company to purchase another property? Annualize the return on both the mutual fund and the real estate venture to see if either one significantly outweighs the other.
Putting the ROI Equations Into Action
The ROI and AROI formulas are incredibly versatile tools with a wide range of uses.
Use them to calculate returns on a single position, or use them to analyze one sector of your portfolio against another. Compare recent tech stock performance against your historic average, or compare returns on the funds you manage yourself against the investments a financial planner oversees for you.
These kinds of results can help you decide which positions to hold, sell, or buy when you’re adjusting your portfolio. You can even swap out fees or expenses to see how changing investments or platforms could impact your returns.
Still, these tools are only the tip of the iceberg when it comes to investment analysis.
For example, you might be considering two investments that have very different risk profiles—such as a small-cap stock and a treasury bond. Even if their ROIs over the last two years are identical, the ROI and AROI formulas don’t consider risk.
In that case, you might want to calculate the risk-adjusted return to determine which will fit best in your portfolio.
Another thing that comes into play when you compare different investments against each other is the expected timing of the investment returns. For example, investing in an ongoing private business might entitle you to a certain portion of the company’s profits at the end of each year. On the other hand, investing in a long-term venture might not provide any cash return for the first 5 years.
To address this difference, investors might turn to yet another tool: internal rate of return, or IRR.
What is the Internal Rate of Return (IRR)?
Internal rate of return is an investment tool that analyzes the equivalent return of an investment based on the payoff, or payoffs, you expect to get from that investment.
It’s easier to see with an example. Let’s say you’re thinking about investing in a startup. They’re asking you for $100,000, and they expect to need 3 years to develop their new product. After that, they’re projecting that you’ll earn $25,000 in year 4, $30,000 in each of the next 2 years, $50,000 in each of the 4 years after that, and $20,000 for 3 more years.
On the other hand, you could just invest your money in the stock market, with historical returns of around 10% per year.
So, which is better?
Internal rate of return calculates an equivalent rate of return for that first investment, so you can compare apples to apples. (At least, sort of.) In this case, an IRR calculator will tell you that all those cash flows have a rate of return that’s equivalent to 17.219%.
The problem, of course, is that these are only expected cash flows. You can’t know for sure that the investment will come through. Every investment has that element of risk, and some investments carry more risk than others.
Still, 17.219% is a pretty good return, so it might be worth the additional risk of an unknown venture.
No matter what you would decide in this hypothetical, the point is that IRR gives you a way to more easily compare that investment to other possibilities.
How is ROI Different from IRR?
To get some insight into the difference between ROI and IRR, let’s calculate the overall ROI of that hypothetical investment and see how it differs from the IRR.
By the end of that 13-year investment, you’re expecting to get a total of $345,000 if you add up all those payouts. $25,000 in year 4, $30,000 in years 5 and 6, and so on.
Using the ROI calculator, if you enter 100,000 for the amount invested and 345,000 for the amount returned, you’ll get an ROI of 245%. That’s a huge difference from the IRR of 17.219%.
Why are they so different? Because ROI ignores time.
The real takeaway here is that it doesn’t just matter how much money you could potentially get from an investment. It also matters when you’re going to get it.
Pros and Cons of ROI Formulas
As you’ve already seen, each formula has different uses. ROI is the simplest, but it also gives you the least information. Annualized ROR and IRR add in the factor of time, but they’re more complicated to use.
Most importantly, none of these factor in the risk of an investment, which is extremely difficult to quantify.
Because of that risk factor, no investment tool should be taken as a sure way to evaluate a potential investment. There’s no such thing as certainty.
Instead, use tools like these along with your own best judgment to evaluate potential investments, and factor in your comfort level in making investment decisions.