Term of the Day: ROI - Return on Investment

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The term of the day that we will examine today is the ROI (Return on Investment). The ROI provides you with insight on what you can expect (returns) for what you spend (cost) on an investment in order to know if the returns justify the costs and to know if the returns outweigh the cost among other things.

Definition: Return on Investment (ROI) refers to a financial performance measure that evaluates the efficiency (benefits/returns in relation to cost) of an investment or for the comparison on the efficiency of different investments.

Explanation

Except you have incredibly deep pockets, you will not be able to allocate enough capital to all the investment opportunities that may come your way. Even if you are only investing in the stock market, you will not be able to buy shares in all the companies into which you would love to own a stake at any point in time.

Hence, it is important that you allocate your investment capital to the investment(s) that promise(s) you the highest returns on the invested capital. The Return on Investment can be calculated using two formulas.

1. Return on Investment = (gain from investment – cost of investment) / cost of investment

2. Return on Investment (%) = (Net profit / Investment) × 100

For instance, let us assume that invested N200, 000 in company A and you invest N300, 000 in company B. At the end of the investment cycle, you have a profit of N50, 000 from company A and a profit of 70,000 from Company B. The ROI from company A will be (250,000 -200,000)/200,000 and it will be equal to 25%. The ROI from company B will be (370,000 – 300,000)/ 300,000 and it give you an ROI of 23%.

You can see that company B offers a lower ROI than company A even though you invested more money (300,000 compared to 200,000 for company A) and you had more profits (70,000 compared to 50,000 from company B). Hence, it would make more sense to allocate more capital to investing in company A if the business fundamental remains unchanged.
 
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