How to Calculate ROI: All You Need to Know

In 2024, 55% of millennials identified stocks as their preferred investment product. But what helps them make calculated decisions? One essential tool is the ROI (Return on Investment) metric. In short, it measures how profitable an investment is relative to its cost. Now, if you’re wondering how to find ROI, keep reading. We’ll explore two methods of ROI calculation and where you can use this powerful metric.

Calculating ROI

Computing ROI is fairly simple. But it’s important to know there are two ways of doing it. The first is the Net Income Method, which focuses on the investment’s net profit. It’s especially helpful for assessing how well an investment generates profit after deducting all expenses.

The second is the Capital Gain Method, which highlights how the investment’s value has increased. This method is suitable for investments like stocks or real estate when the main goal is value growth. To determine which of the two methods is better, consider your investment objectives and specific circumstances. Both provide valuable insights into investment performance.

First Method

The first approach is easy to follow. You need to apply this return on investment formula:

ROI = Net Income / Total Cost of Investment x 100

To measure ROI correctly, follow these steps:

Step 1: Determine Net Income

First, find the net return on the investment. For that, deduct all related expenses from the total income. That could be the cost of the work, necessary subscriptions for certain services, taxes, office rent, advertising, etc. Use this formula:

Net Income = Total Revenue − Total Expenses

For example, a small business owner invests $50,000 in a coffee shop and wants to calculate ROI after one year. The first year’s total revenue for the coffee business is $80,000. However, the owner also had to spend $15,000 on rent, $10,000 on supplies and inventory, and $5,000 on marketing and other costs. In addition, he has to pay the salaries of his personnel, which is $25,000.

So, he needs to subtract all these costs from the revenue to determine net income:

Net Income = 80,000 − (15,000 + 25,000 + 10,000 + 5,000)Net Income = 80,000 − 55,000 = 25,000

Step 2: Identify the Initial Investment Cost

Next, find out how much money was invested in total. This refers to the total amount spent on the purchase, including any other related expenditures necessary for obtaining the investment.

So, following our example, the total investment is $50,000, covering expenses such as furnishings, equipment, and license fees.

Step 3: Apply the ROI Formula

Now, divide the net income by the total investment cost. After that, to express the result as a percentage, multiply it by 100.

ROI = (25,000 / 50,000) × 100ROI = 0.5 × 100 = 50%

Alternative Method: Capital Gain Approach 

Now, let’s learn how to calculate ROI using the capital gain method. This formula compares the final value of the investment to its initial value.

ROI = (Final Value − Initial Value) / Cost of Investment ​×100

Step 1: Determine the Initial Value of the Investment

First, identify how much money you initially invested in the project. That covers the cost of purchase and other associated expenses.

Suppose you invest $5,000 in company stocks. That will be the initial value of the investment.

Step 2: Identify the Final Value of the Investment

Then, find the current selling price of the investment. If you sell the investment now, you’ll receive this sum.

So, returning to company shares. Three years later, they've increased in value to $6,500, which is the terminal value of the investment.

Step 3: Calculate the Capital Gain

The capital gain is calculated by deducting the initial investment amount from the final value. This number illustrates the amount that your investment has increased in worth.

$6,500 (Final Value) − $5,000 (Initial Investment) = $1,500

Step 4: Apply the ROI formula

Finish the ROI calculation by taking the capital gain and dividing it by the original investment. Afterward, multiply that figure by 100 to express it as a percentage.

ROI = ($1,500 / $5,000) × 100 = 30%

When to Use ROI

Because ROI is easy to calculate and interpret, it’s widely used across different financial decisions. It’s versatile and can be used as a basic indicator of the financial return on an investment. Whether it’s stocks, real estate, or advertising, ROI will show how efficient your investment has been. Here are key scenarios where this metric plays a crucial role:

Evaluating Business Investments

Entrepreneurs often ask, “How to measure ROI?” when considering business expansions. For example, a company wants to scale and open a new store. Before opening a new store, a business owner can use ROI to determine whether the expected revenue will justify the initial investment, allowing it to determine whether the expansion is cost-effective. A high ROI indicates a profitable decision.

Analyzing Stock Market Investments

By buying stocks, investors can use ROI to evaluate performance over time. If they compare the purchase price to the selling price, they can determine whether the stock has increased in value. If the ROI is low or negative, they might decide to sell or adjust their investment strategy.

Monitoring Marketing Campaigns

Calculating return on investment is often used in marketing to track the effectiveness of marketing campaigns. It helps businesses measure the increase (or decrease) in sales and subscriptions after launching a campaign. Marketers can also analyze which campaigns and channels drive the best returns.

Conclusion

ROI is an essential tool for measuring profitability and making sound financial decisions. Whether you’re investing in marketing, stocks, or a business venture, tracking ROI helps you optimize your strategy and achieve long-term profit growth with a suitable technique. By carefully evaluating ROI, you can make smarter investment decisions and build a successful financial portfolio.