Why prioritize return on investment (ROI)?
What is ROI, and why is understanding it so important? This article explores the value of this profitability-focused performance measure.
What is ROI?
ROI is shorthand for the phrase “return on investment.” It’s a performance measure used to assess the potential profitability of an investment OR to compare the efficiency of several different investments. Generally speaking, you can define it as:
Net profit earned through investment ¸ Total cost of investment = Investment’s ROI
ROI, usually expressed as a percentage, is concrete and measurable. It’s helpful both to business owners analyzing their goals and investors assessing the viability of different market options. It’s especially useful and popular because it can be applied across many investment types and industry contexts. ROI can help you to determine:
Annual returns
Total investment returns
Return on equity (ROE)
Return on assets (ROA)
Return on invested capital (ROIC)
Return on capital employed (ROCE)
ROI could enable you to directly compare two investments you’ve made in similar companies, discovering which is performing better and offering you a greater return on your initial investment. Conversely, ROI could help a small business owner assess a particular marketing campaign's success, comparing their ad spend with the net profit gained from that expenditure.
Why is understanding ROI so useful?
ROI is a Key Performance Indicator (KPI), often used as a metric when people want to set measurable goals. This goes for business owners aiming for a specific ROI on projects being undertaken companywide and investors seeking a good ROI on investments across their portfolio. Whichever you are, a proper understanding of ROI will benefit you.
No matter the size of the business or the industry it’s operating in, from finance to skincare, ROI is a viable and effective calculation that will tell you whether or not you’re getting your money’s worth. Investors can use ROI:
To see whether an investment is growing, shrinking, or stagnating
To compare investments with each other on a like-for-like basis
To analyze their practices and processes by measuring time (and money) spent on projects/investments against profit gained
Meanwhile, business owners can look to ROI:
When purchasing new tools, equipment, and products, from heavy machinery to accounting software
When hiring new employees (understanding which employees bring the most value to the company will inform future hiring decisions)
When adding a new department to your business (ROI will help you identify suitable, profitable areas of expansion)
When tracking and managing sales strategies
How to calculate your ROI
Having answered the question of “What is ROI?”, we must now look, in more detail, at how ROI is calculated. The specifics depend on the type of calculation you’re trying to make (and we’ll explore an example in a moment). Generally, determining your ROI means taking that initial ROI meaning:
Net profit earned through investment ¸ Total cost of investment = Investment’s ROI
And converting it into a percentage:
(Net profit earned through investment ¸ Total cost of investment) x 100 = ROI percentage
An example: Sally owns an e-commerce website that sells silk ties, accessories, and fascinators. It’s wedding season, and she knows she wants to get as much business as possible, so she spends $2,000 on advertising campaigns on social media to get the word out there.
At the end of the wedding season, Sally can calculate the summer advertising’s ROI by figuring out the net profit gained from the campaigns, dividing this by the cost of the campaigns, and multiplying that figure by 100.
The net profit shows that Sally earned $6,000 more than she did in the same timeframe the previous year, meaning $6,000 divided by $2,000 multiplied by 100 leads her to an ROI of 300 percent. This means that for every dollar Sally spent on her advertising, she gained back $3 in return.
What’s a “good” ROI?
The ROI profitability measure is an excellent tool for businesses, investors, and financial advisors. But what is a “good” ROI? It depends. Since ROI can be widely applied in many situations and areas, a “good” ROI depends on context.
Looking at investments in stocks and what would be a “good” ROI in this context, we see that many finance professionals agree that an ROI of over 10.5 percent is “good.” This is the average return for the S&P 500, an index that serves as a performance benchmark for the US stock market.
Even in stocks, though, there’s variation. Different industries have different averages, and thus, it’s essential to do your research and properly understand ROI in context. As of 2023 Q1, these are the top four industries according to their ROI rankings:
Energy, with 19.99 percent ROI.
Technology, with 12.52 percent ROI.
Retail, with 9.5 percent ROI.
Capital goods, with 9.25 percent ROI.
The benefits and limitations of ROI as a measurement
| The benefits of ROI | The limitations of ROI |
|---|---|
| It’s a successful, quantifiable, and widely used measure of efficiency/profitability. | The calculation of profit over investment amount can be vague enough that it’s open to false reporting or misinterpretation. |
| It’s great for setting and measuring progress toward goals (it’s a KPI). | It can create a false equivalency when used to compare companies with very different accounting policies. |
| It allows for simple, straightforward comparative analysis. | It can’t tell the future and doesn’t always account for the long term. |
| It offers investors a simple summary of a stock/company’s performance. | |
| Since it’s so widely used, combining it with other measures in a broader investment strategy is easy. |
There’s much to love about ROI as a performance metric, provided you use it correctly. When you can compare investments on level ground or assess the return of an ad campaign on an exact micro scale, ROI enables you to gather sound, valuable and worthwhile insights.
You should now know the necessary information to make ROI a part of your process, whether as an investor or a small business owner.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.