What is ROI? From the calculation formula to practical application, master the core logic of return on investment in one article

The Essence of ROI: The Key Indicator for Measuring Investment Profitability

Return on Investment (ROI) is the most commonly used profitability metric in the investment field, presented as a percentage to reflect the earning ability of an investment. Whether for personal finance or corporate project evaluation, ROI is regarded as a fundamental indicator for assessing investment efficiency.

In simple terms, ROI is the percentage of net profit (or loss) divided by the total invested capital. Net profit equals investment income minus investment costs. This logic seems straightforward, but in practical application, it involves many details.

ROI Calculation Formula

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

Or more intuitively:

ROI = ((Investment Income - Investment Cost) ÷ Investment Cost) × 100%

For example, in stock investment: you buy a stock for 1 million, and later sell it for 1.3 million, then ROI = ((1.3 million - 1 million) ÷ 1 million) × 100% = 30%.

However, in real operations, calculating income and costs is far more complex. Taking stock investment as an example: suppose you buy 1,000 shares at $10 each, sell them a year later at $12.5, receive $500 in dividends, and pay a total transaction fee of $125.

The calculation becomes more complex:

• Total income = ($12.5 × 1,000) + $500 = $13,000
• Total costs = ($10 × 1,000) + $125 = $10,125
• Net profit = $13,000 - $10,125 = $2,875
• ROI = $2,875 ÷ $10,000 × 100% = 28.75%

Different Industry Logic for ROI Calculation

In e-commerce and advertising, ROI has different meanings. The formula for advertising ROI is:

ROI = (Sales Revenue - Cost of Goods Sold) ÷ Cost of Goods Sold × 100%

Suppose the production cost of a product is $100, selling price is $300, 10 units are sold through advertising, with an advertising expense of $500, then:

• ROI = [($300 × 10) - ($100 × 10 + 500)] ÷ (($100 × 10 + 500)) × 100% = 100%

It’s important to note that in casual conversation, “advertising ROI” often refers to ROAS (Return on Ad Spend), calculated as:

ROAS = Revenue generated from traffic ÷ Cost of traffic

Using the above example, ROAS = (($300 × 10) ÷ 500) = 600%.

The fundamental difference is: ROI measures profit margin, ROAS measures revenue rate; ROI considers product costs, ROAS only accounts for advertising costs.

Annualized Return: Overcoming the Time Dimension Limitation

A major flaw of basic ROI is that it does not consider the length of the investment period. This is why Annualized ROI is introduced.

Annualized ROI is expressed in English as “Annualized ROI,” and its formula is:

Annualized ROI( = [)Total Return Rate + 1(^)1 ÷ Number of Years( - 1] × 100%

This metric more accurately reflects the average annual profitability of an investment, also accounting for compound interest.

Compare: Investment A yields 100% over 2 years, Investment B yields 200% over 4 years. Which to choose?

Calculations:

• A: [)1 + 1(^)1/2( - 1] × 100% = 41.4%
• B: [)2 + 1(^)1/4( - 1] × 100% = 31.6%

The conclusion is to choose Investment A, as it has a higher annualized return.

The Difference Between ROI, ROA, and ROE

In corporate financial analysis, ROI is not the only profitability indicator; understanding the differences between ROA and ROE is also essential:

Example: A company has assets of $1 million, with $500,000 in debt and $500,000 in equity. The company invests $100,000 in a project, which ultimately yields $200,000.

• ROI of the project = )(200,000 - 100,000) ÷ 100,000( × 100% = 100%
• Annual total profit = $1.5 million, ROA = 150% = 150 ÷ 100 × 100%
• Same year, ROE = 300% = 150 ÷ 50 × 100%

How to Improve Investment Return Rate

Based on the ROI calculation logic, increasing returns can only be achieved through two directions: increase profits or reduce costs.

In stock investment, this means choosing high-dividend stocks, using low-fee trading platforms, and reducing trading frequency. However, these micro-optimizations have limited effects; a more direct approach is to select investment products with inherently higher ROI.

Generally, the ranking of ROI among investment types is: Cryptocurrency & Forex > Stocks > Indexes & Funds > Bonds

But note that high ROI often comes with high risk. For example, in cryptocurrencies, if a coin’s volatility ratio compared to traditional stocks is 7:3, investors can adjust their positions to 3:7 to balance risk and return.

Additionally, evaluating valuation levels is important. When comparing two indices, the one with a lower PE percentile (current valuation relative to historical levels) not only carries less risk but may also offer greater potential returns.

Main Investment Methods to Increase ROI

) Contract for Difference (CFD)###

CFD is an over-the-counter trading instrument that allows leverage with low margin. For example, stock CFDs require only 20% of the trading amount. An investor holding $10,000 only needs $2,000 to trade. If the trade profits $500, ROI = $500 ÷ $2,000 × 100% = 25%, which is a substantial return.

( Forex Margin Trading

The forex market is the world’s largest financial trading market, employing two-way profit and leverage, open 24 hours. The annual return rate of forex investments can sometimes exceed 30%. However, due to the significant influence of international factors, it demands higher experience and risk management skills from investors. Properly setting stop-loss and take-profit mechanisms can effectively protect principal.

) Gold Investment

Gold has the function of preserving and increasing value, making it a classic hedging tool. In 2019, international gold prices increased by 18.4%, reaching an 8-year high. During periods of economic volatility, gold investment is a good choice.

Stock Investment

The stock market is a relatively mature financial market. For example, historical data from the US stock market over the past 200+ years shows an average annual return exceeding 12%. Its characteristics of low valuation and high dividends, along with policy support, make it a preferred choice for long-term investors.

Important Limitations of Using ROI

Although ROI is widely applied, it also has obvious limitations that investors need to recognize.

Ignoring the Time Dimension

Suppose project X has an ROI of 25%, and project Y has 15%. But if X takes 5 years to realize, and Y only 1 year, comparing only the ROI figures can lead to incorrect conclusions. That’s why annualized return should be used for comparison, as it more accurately reflects the true return level of projects.

High ROI Implies High Risk

Investment returns are positively correlated with risk. Ignoring volatility and other risk indicators when evaluating ROI can lead to investment outcomes far from expectations. High-ROI projects may face initial losses, causing investors to panic and exit prematurely.

ROI Can Be Overestimated

If some costs are omitted during calculation, ROI will be overestimated. For example, in real estate investment, one must consider mortgage interest, taxes, insurance, and maintenance costs. Omitting these expenses can severely inflate the yield.

Ignoring Non-Financial Benefits

ROI focuses solely on financial gains and ignores other auxiliary benefits such as social impact and environmental gains. This can lead to underestimating the actual value of some projects. As a response, new evaluation indicators like “Social Return on Investment” have been proposed.