Return on investment is one of the most basic (and important) terms that you would encounter commonly in the world of investments. You know your investment goals and you know about the different instruments (investment options) available in the market. So, how do you decide which instruments to invest in and which to leave? How do you decide which instruments are better than others?
The simple ratio that can enable you to answer these questions quickly and accurately is the return on investment ratio. This ratio tells us the profitability of an investment, i.e. how much profits you made on every dollar that you invested. Thus, this simple tool can quickly and easily allow us to compare many different types of investments. This, in turn, allows us to decide which of the investment options being considered are better and thus, enables us to make good investment decisions. So, let us quickly understand the concept of return on investment.
The ratio, return on investment, is defined simply as net income on an investment divided by amount invested. Let us understand this ratio better through a simple example.
Suppose you buy 100 shares of company A today. Each of these shares cost you $30. Thus, the total sum of money that you invested in these shares = $30 X 100 = $3,000.
Two years later, you sell these shares for $45 each. Can you calculate the return on investment achieved in this case?
Well, if you calculated the return on investment as 50%, then you are absolutely right. In this case, total income from sale of shares = $45 X 100 = $4,500.
Net income = Total income – total cost (i.e., amount invested)
Hence, Net income = $4,500 – $3,000 = $1,500
Thus, return on investment = net income/amount invested = $1,500 / $3,000 = 0.5 or 50%.
There you are – you have understood how to calculate the profitability of an investment. Let us try one more example to understand this concept better.
Suppose you buy 100 shares of company Y for $50. Three years later, you sell these shares for $70 each. Is this investment better (more profitable) than the previous investment (the one in company A?
Let us see how we can quickly answer this question. We have already seen that the return on investment in the previous case (investment in shares of company A) is 50%. Now, we need to calculate the return on investment for the second case (i.e., the investment in shares of company Y).
In this case, total amount invested = $50 X 100 = $5,000
Total income = $70 X 100 = $7,000
Net income = Total income – total cost = $7,000 – $5,000 = $2,000
Thus, return on investment = net income/amount invested = $2,000 / $5,000 = 0.4 = 40%
Hence, while the first investment (investment in shares of company A) yields a return on investment of 50%, the second investment (investment in shares of company Y) yields a return on investment of 40% only. Thus, the first investment is more profitable than the second one (i.e., per dollar invested, the first investment yields higher returns – greater profits – than the second investment).
Do note that in the first case the profit per share is $15 (profit per share = sale price – purchase price = $45 – $30 = $15) whereas in the second case the profit per share is $20 (profit per share = sale price – purchase price = $70 – $50 = $20). Hence, if we only consider profit per share, we may get the impression that the second investment is more profitable. But, we need to realise that the cost of investment in the second case is much higher (cost of investment in the first case = $3,000 while cost of investment in the second case = $5,000). Hence, the return on investment, per dollar invested, is actually higher in the first case. This is how return on investment gives us a much more accurate picture as it considers the cost of investment as well.
You have now understood how to calculate return on investment and have understood how to compare two or more investments using this wonderful tool. Let us now look at two useful rules/tips regarding return on investment.
There are two general rules about return on investment that may come in handy for you. Do note that there may be many exceptions to these rules. Hence, you should not unquestioningly follow these rules. Instead, always try to perform precise calculations and determine the exact return on investment for each of the investment opportunities that you are trying to analyse. This would enable you to accurately judge which investment opportunity is better.
Typically, in the investment world, if an investor comes across two investment opportunities, one of which is safer than the other, then the investor would prefer to invest in the safer option if both options offer the same return (equal return). The investor would only choose the riskier option if it offers higher return. Thus, instruments that are riskier will generally be priced in a manner that ensures that they offer higher returns than safer instruments.
The implications of this are obvious. Suppose you come across two instruments, one of which offers significantly higher returns than the other (and hence appears far more appealing). In this case, do not choose the instrument with the higher return without further analysis. It is possible that this instrument is riskier than the other one. Study both instruments deeper, identify the level of risk that each carries and then decide which instrument you wish to invest in.
Suppose you come across two investment opportunities, one of which requires that you invest your money for two years while the other requires investment for three years. In this case, if both opportunities offer equal returns, then it is better to invest your money in the first one since it requires investment for less time. You can then reinvest your money and get some more returns over the extra year that you save here. Thus, if the second investment opportunity does not offer higher returns then it may not be very sensible to invest in this opportunity. Hence, in general, you would observe that instruments that require longer periods of investment may offer higher returns. This implies that if you want higher returns on your investment, then looking for opportunities with longer periods of investment may reveal ideal options for you.
Do note that both of these are general guidelines only – it is not at all necessary that every instrument will follow these rules. Hence, analyse each investment opportunity thoroughly before you make your investment decision.
You have now understood how to use return on investment to accurately evaluate various investment options. Use this wisely and invest your way to success and profits.