If you want to see how certain assets are benefiting (or hurting) you or your business, you need to learn to use the return on investments (ROI) formula. Luckily, calculating ROI is pretty straightforward, but there are a lot of caveats you need to consider. Here is a look at the essentials.
Return on Investments Formula | How Much Have Your Investments Grown?
In This Article:
- The Return on Investments Formula Simplified
- Comparing the Return on Different Investments
- Determining the Cost of the Initial Investment
- Return on Investment for Real Estate
- Your Time Is Valuable
- Compound Annual Growth Rate (CAGR)
The Return on Investments Formula Simplified
The return on investments formula is simple: To calculate ROI, take the amount you earned from the investment and divide that by the cost of the investment.
To explain, imagine you purchased $1,000 in stocks. Then, you sold the stocks for $1,500. You earned $500 on the sale.
When you divide that by the amount you spent, the formula is $500 / $1,000 = 0.50. To turn that number into a percentage, multiply it by 100. You have a 50% return on your investment.
Comparing the Return on Different Investments
Using the return on investments formula allows you to compare investments that bring in vastly different amounts of profits.
For instance, if you buy a stock for $1 and you sell it for $10, that is $9 in profit. In contrast, if you buy a stock for $1,000 and sell it for $3,000, that is $2,000 in profit. ROI lets you compare these two numbers easily.
At first glance, the $2,000 gain looks better. After all, it put an extra $1,991 in your pocket compared to the $10 stock. However, when you use the return on investments formula, you get a strikingly different picture.
You earned $9 on the first stock, and when you divided that by your purchase price of $1, you had a 900% return on your investment. On the other hand, the other stock earned $2,000 in profit. When you divided that by your purchase price of $1,000, the return on investment came out at 200%.
It means you could have made more money overall if you bought lots of the $1 stock than the $1,000 stock.
Determining the Cost of the Initial Investment
The above examples are simplified, but in a lot of cases, there are a number of additional inputs you need to consider.
To continue with the stock example, imagine you have to pay $20 for every stock you buy. If you want to calculate your rate of return accurately, you need to take that number into account and find your net profit.
Now, imagine you bought a stock for $1, but the $20 fee increases the initial investment to $21. When you sell the stock for $10, you actually end up losing $9. Your net profit is negative $9. As a result, your ROI is -$9 / $21 = -42.9%.
Meanwhile, with the $1,000 stock, you also paid a $20 trading fee, bringing your initial investment to $1,020.
Then, when you sold the stock for $3,000, you ended up with $1,980 in net income. When you divide the gain ($1,980) by your initial investment ($1,020), you get 194%.
As you can see, considering the full initial investment significantly changed the ROI on both of your investments. More importantly, it revealed the $1,000 stock actually offered a better return.
Return on Investment for Real Estate
You can also use the return on investments formula on real estate investment. When calculating the ROI, however, you cannot just consider the price you paid for the property and the price for which you sold it.
You also need to remember the money you spent fixing up the property, buying new appliances, or hiring real estate agents. If you made anything while you owned the property, you may also want to take that into consideration as you do your calculation.
Let us say you bought a house for $200,000. Then, you spent $50,000 fixing up the house, and you also paid real estate agents $5,000 to help you buy and sell the property.
While you owned the property, you rented it out for 10 months, and you charged $1,000 per month, so you made $10,000 in rent. Finally, you sold the home for $300,000.
In this situation, you earned $300,000 on the sale plus $10,000 in rent for a total of $310,000. However, you spent $200,000 buying the house plus $50,000 in expenses and $5,000 in real estate agent fees, bringing your total investment to $255,000.
To find out how much you really earned on the home, you subtract $255,000 from $310,000, and you get $55,000. Then, you can proceed with the return on investments formula. Divide that by your initial investment ($255,000), and the result is 21.6%.
Of course, these rules do apply not only to real estate. You should also think about other income and expenses when you are calculating the ROI on any investment.
Your Time Is Valuable
With certain investments, you may want to consider the time you put in. This idea does not apply to situations where there is not a huge time investment. For instance, buying a CD, stock, or bond does not take a significant amount of time, so it does not make sense to track that.
To return to real estate, imagine you are flipping houses and do a lot of the labor (painting, landscaping, repairs, etc.) on your own. To factor in your time, you may want to assign yourself an hourly wage, and then see how that affects your rate of return.
Let us say you spent $150,000 on one house and sold it for $200,000. You have earned a 33% return on your investment.
Then, you bought another house for $200,000 and sold it for $300,000, earning a 50% rate of return, but you spent only 10 hours fixing up the first house and 1,000 hours on the second property.
If you decide your time is worth $25 per hour, it means you invested an extra $250 into the first house and $25,000 into the second house.
Now the equations go as follows:
Sample: [Selling Price – (Purchase Price + Value of Time)] / (Purchase Price + Value of Time) = ROI
- House 1: ($200,000 – [$150,000 + $250]) / ($150,000 + $250) = 33.1%
- House 2: ($300,000 – [$200,000 + 25,000]) / ($200,000 + $25,000) = 33.3%
As you can see, once you include your time, the two houses have roughly the same rate of return.
Compound Annual Growth Rate (CAGR)
Your time is not the only factor to consider when calculating using the return on investments formula. Another is the length of time the investment took to grow.
If one investment earns a 100% rate of return over a 10-year period while another has the same rate of return over a 6-month period, the latter investment is more lucrative. Although they both have the same rate of return, the second investment earned its return much more quickly.
To get a sense of how time affects your ROI, you may want to calculate the Compound Annual Growth Rate (CAGR). It shows you how much the investment earned if you break it down year by year.
This formula is a bit more complicated than the basic ROI formula, so you will need a calculator. It looks like this: (End Value of the Investment / Initial Value of the Investment) 1 / n – 1.
In this equation, n is the amount of time you had the asset.
To see how that works, let us plug some numbers into this equation:
Imagine you invested $10,000, and 10 years later, you sold the investment for $20,000. Right off the bat, you know your ROI is 100%, and when you put these numbers into the equation, you get this: ($20,000 / $10,000) 1 / 10 – 1 = 0.072. If you turn that into a percentage, you have 7.2%.
It means, theoretically, your investment grew by 7.2% every year, and of course, that growth is compounded.
The first year, your investment grew to $1,700. Then, the next year, it earned interest on the interest, so it grew to $11,449, and the process continued from there.
In reality, however, most investments do not grow at a steady rate. When you calculate CAGR, you get a nice number that lets you compare the theoretical growth of your investment over time to the growth of others.
Have you used the return on investments formula? How was it? Let us know in the comments section below!