A generic term to define a number of analytical tools for measuring the financial benefits of an investment, including cash-on-cash, internal rate of return, equity dividend,and financial management rate of return. Return on investment ROI Generally, book income as a proportion of net book value.
All Rights Reserved. Farlex Financial Dictionary. A measure of the net income a firm's management is able to earn with the its total assets. Return on investment is calculated by dividing net profits after taxes by total assets.
Also called rate of return , return on assets. Compare profitability ratio. Published by Houghton Mifflin Company. Cancel Submit. Your feedback will be reviewed. What is the pronunciation of return on investment? Browse return on capital. Test your vocabulary with our fun image quizzes. Image credits. Word of the Day budget. Read More. New Words genetic scissors. November 23, To top. Get our free widgets. Add the power of Cambridge Dictionary to your website using our free search box widgets.
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It even includes a k investment. An omnibus term like profit could mean gross, operating, net, before tax, or after tax. Holding period return may be expressed nominally or as a percentage. When expressed as a percentage, the term often used is rate of return RoR. For example, the return earned during the periodic interval of a month is a monthly return and of a year is an annual return.
Often, people are interested in the annual return of an investment, or year-on-year YoY return, which calculates the price change from today to that of the same date one year ago. Returns over periodic intervals of different lengths can only be compared when they have been converted to same length intervals. It is customary to compare returns earned during year-long intervals. The process of converting shorter or longer return intervals to annual returns is called annualization.
A nominal return is the net profit or loss of an investment expressed in nominal terms. It can be calculated by figuring the change in the value of the investment over a stated time period plus any distributions minus any outlays. Distributions received by an investor depend on the type of investment or venture but may include dividends , interest, rents, rights, benefits, or other cash-flows received by an investor. A positive return is the profit, or money made, on an investment or venture.
Likewise, a negative return represents a loss, or money lost on an investment or venture. A real rate of return is adjusted for changes in prices due to inflation or other external factors. Adjusting the nominal return to compensate for factors such as inflation allows you to determine how much of your nominal return is real return.
Knowing the real rate of return of an investment is very important before investing your money. Investors should also consider whether the risk involved with a certain investment is something they can tolerate given the real rate of return.
Expressing rates of return in real values rather than nominal values, particularly during periods of high inflation, offers a clearer picture of an investment's value. Return ratios make this comparison by dividing selected or total assets or equity into net income. For instance, return of capital ROC means the recovery of the original investment.
A percentage return is a return expressed as a percentage. It is known as the return on investment ROI. ROI is the return per dollar invested. ROI is calculated by dividing the dollar return by the initial dollar investment. This ratio is multiplied by to get a percentage. Return on equity ROE is a profitability ratio calculated as net income divided by average shareholder's equity that measures how much net income is generated per dollar of stock investment.
Return on assets ROA is a profitability ratio calculated as net income divided by average total assets that measures how much net profit is generated for each dollar invested in assets. It determines financial leverage and whether enough is earned from asset use to cover the cost of capital. Net income divided by average total assets equals ROA.
In the equation above, the numeral 0. Annualized ROI is especially useful when comparing returns between various investments or evaluating different investments. You can determine what the better investment was in terms of ROI by using this equation:. Leverage can magnify ROI if the investment generates gains. However, by the same token, leverage can also amplify losses if the investment proves to be a losing investment.
Assume that an investor bought 1, shares of the hypothetical company Worldwide Wickets Co. When calculating the ROI on this specific, hypothetical investment, there are a few important things to keep in mind. In this situation, the investor decides to cut their losses and sell the full position. Here is the calculation for ROI in this scenario:. In this case, the ROI of When evaluating a business proposal, it's possible that you will be contending with unequal cash flows.
In this scenario, ROI may fluctuate from one year to the next. This type of ROI calculation is more complicated because it involves using the internal rate of return IRR function in a spreadsheet or calculator. This investment will generate cash flows over the next five years; this is shown in the "Cash Inflow" row. The row called "Net Cash Flow" sums up the cash outflow and cash inflow for each year.
The final column shows the total cash flows over the five-year period. In this case, the IRR is now only 5. The substantial difference in the IRR between these two scenarios—despite the initial investment and total net cash flows being the same in both cases—has to do with the timing of the cash inflows.
In the first case, substantially larger cash inflows are received in the first four years. Because of the time value of money , these larger inflows in the earlier years have a positive impact on IRR. The biggest benefit of ROI is that it is a relatively uncomplicated metric; it is easy to calculate and intuitively easy to understand. ROI's simplicity means that it is often used as a standard, universal measure of profitability.
As a measurement, it is not likely to be misunderstood or misinterpreted because it has the same connotations in every context. There are also some disadvantages of the ROI measurement. First, it does not take into account the holding period of an investment, which can be an issue when comparing investment alternatives.
One cannot assume that X is the superior investment unless the time-frame of each investment is also known. Calculating annualized ROI can overcome this hurdle when comparing investment choices. Second, ROI does not adjust for risk. It is common knowledge that investment returns have a direct correlation with risk: the higher the potential returns, the greater the possible risk.
If an investor hones in on only the ROI number without also evaluating the concomitant risk, the eventual outcome of the investment decision may be very different from the expected result. Third, ROI figures can be exaggerated if all the expected costs are not included in the calculation.
This can happen either deliberately or inadvertently. For example, in evaluating the ROI on a piece of real estate , all associated expenses should be considered. These expenses can subtract a large amount from the expected ROI; without including all of them in the calculation, a ROI figure can be grossly overstated. Finally, like many profitability metrics, ROI only emphasizes financial gains when considering the returns on an investment.
It does not consider ancillary benefits, such as social or environmental goods. Return on investment ROI is a simple and intuitive metric of the profitability of an investment. There are some limitations to this metric, including that it does not consider the holding period of an investment and is not adjusted for risk.
However, despite these limitations, ROI is still a key metric used by business analysts to evaluate and rank investment alternatives. Financial Ratios. Real Estate Investing. Financial Analysis. Your Money. Personal Finance. Your Practice. Popular Courses. Financial Analysis How to Value a Company.
Likewise, investors should avoid negative ROIs , which imply a net loss. With this information, he could compare his investment in Slice Pizza with his other projects. See Limitations of ROI below for potential issues arising from contrasting time frames. Examples like Joe's above reveal some limitations of using ROI, particularly when comparing investments.
Joe could adjust the ROI of his multi-year investment accordingly. One may also use Net Present Value NPV , which accounts for differences in the value of money over time, due to inflation. SROI was initially developed in the late s and takes into account broader impacts of projects using extra-financial value i.
For instance, a company may undertake to recycle water in its factories and replace its lighting with all LED bulbs. These undertakings have an immediate cost which may negatively impact traditional ROI—however, the net benefit to society and the environment could lead to a positive SROI.
There are several other new flavors of ROI that have been developed for particular purposes. Social media statistics ROI pinpoints the effectiveness of social media campaigns—for example how many clicks or likes are generated for a unit of effort. Similarly, marketing statistics ROI tries to identify the return attributable to advertising or marketing campaigns.
So-called learning ROI relates to the amount of information learned and retained as a return on education or skills training. As the world progresses and the economy changes, several other niche forms of ROI are sure to be developed in the future. Return on investment ROI is calculated by dividing the profit earned on an investment by the cost of that investment. Although ROI is a quick and easy way to estimate the success of an investment, it has some serious limitations.
For instance, ROI fails to reflect the time value of money, and it can be difficult to meaningfully compare ROIs because some investments will take longer to generate a profit than others. For this reason, professional investors tend to use other metrics, such as net present value NPV or the internal rate of return IRR.
All else being equal, investors who are more risk averse will likely accept lower ROIs in exchange for taking less risk. Likewise, investments that take longer to pay off will generally require a higher ROI in order to be attractive to investors.
Within that, though, there can be considerable variation depending on the industry. For instance, during , technology companies such as Apple Inc. MSFT , and Amzon. Meanwhile, companies in other industries, such as energy companies and utilities, generated much lower ROIs and in some cases faced losses year-over-year. Over time, it is normal for the average ROI of an industry to shift due to factors such as increased competition, technological changes, and shifts in consumer preferences.
World Health Organization. Accessed August 8, Financial Analysis. Farlex Financial Dictionary. A measure of the net income a firm's management is able to earn with the its total assets. Return on investment is calculated by dividing net profits after taxes by total assets. Also called rate of return , return on assets. Compare profitability ratio.
Published by Houghton Mifflin Company. All rights reserved. Dictionary of Financial Terms. Collins Dictionary of Business, 3rd ed.