Return on Investment or ROI Analysis is used by the analysts to assess the profitability of an investment in detail. Analysts also use it for comparing different investments. The reason why we call the benefit from an investment as a return rather than profit is that the return can be negative as well while profit is always positive. Of course, a positive ROI would suggest that an investor has made a gain on an investment in comparison to the negative ROI where the investor loses on the investment.
To fully understand ROI analysis, we will have to understand ROI and its calculation.
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How to Calculate ROI?
The two elements of measuring the efficiency of the investment are return and cost. An analyst compares the return of investment against the cost to determine whether or not the value of the investment has gone up. To find the return on investment, one needs to divide the return by the cost of the investment. One can express the resultant number either as a percentage or ratio.
An investor buys 1,000 shares of ABC ltd at $10 each and sells at $12. There was a dividend amount of $500 over the one-year holding period as well. However, trading and commission charges for buying and selling the shares are $130. Return on Investment (ROI) in this case would be;
ROI = [($12-$10) x 1000] +$500 – $130 = 23.70%
$10 x 1,000
Other ways in which we can calculate ROI are:
ROI = Net Income from the investment/ Cost of the Investment
=> ROI = Investment gain/ Investment base
=> ROI = (Revenue – COGS)/ COGS
ROI = Net Income/ Total Assets
What is ROI Analysis?
As the term implies, it means analyzing the ROI, or understanding what it tells. An ROI analysis can be in two ways. First, by comparing the ROI between periods or between companies or with the industry average, and second, by breaking down ROI components into parts, and then study each of these.
The first one is simple as in this we just have to compare the ROI with the relevant factor. For instance, Company A has an ROI of 10% and Company B, which operates in the same segment and is of the same size as the former, has an ROI of 8%. In this case, we can say that Company A is better.
The second way of breaking down ROI components into parts is a bit complex. Let’s understand this with the help of a company’s ROI. ROI for a company (Net Income/ Total Assets) is made up of two parts – the asset turnover and the company’s profit margin (Net Income/Sales X Sales/Total Assets). So, we can study each of the two components for better understanding.
The first part (Income/Sales) represents the net profit margin. And, the second part (Sales/Total Assets) represents the Asset Turnover. Now, we can study each of these parts separately to find which is causing a problem with the ROI. This method of breaking down profitability into components is called Dupont.
ROI Analysis – Why It Is Important? or Advantages
Return on Investment is a simple calculation but provides very useful and first-hand information to the investors about their investment. The ROI analysis further helps investors and management to gauge if they should continue the investment in a specific instrument or project or look for other alternatives. Apart from these, there are more reasons why ROI analysis is important;
- ROI is one of the profitability ratios. It is one of the simplest measures for investors to understand the profitability of their return. Thus, the analysis helps investors and management in comparing various investment opportunities.
- One can also use ROI analysis to calculate and compare the return of the current and previous periods for better understanding of the portfolio performance.
- Fund managers carry ROI analysis on the portfolios to understand the competitiveness in the market.
- Since ROI analysis is not much complicated, investors do not need much assistance to understand it. Also, numbers or parameters required to calculate the ROI are easily available in the financial statements in the traditional accounting system.
- Carrying ROI analysis on different divisions helps in understanding the pain points, and therefore, assists in resolving the issues as well.
- ROI analysis could also help in constructing a better portfolio by regularly assessing the ROI of different sectors and changing the portfolio mix accordingly. Also, investors or analyst can magnify the return by doing a sector breakdown and then carrying ROI analysis.
- Just like we can define profit in several ways, investments also have different connotations. These are net book value, gross books value, the current or historical cost of assets and so on. It becomes challenging for investment managers to define investment while performing an ROI analysis.
- All companies may not follow the same accounting principles or define investment in the same way. Therefore, it might become difficult for the investors or the fund managers to carry ROI analysis on different companies or the portfolios.
- If the managers are only calculating the ROI of all investments and not focusing on the value that the portfolio, division or the company is offering, there might be chances that a good investment with potential for value enhancement may get overlooked.