This page and guide will help you learn how to calculate return on investment (ROI). In addition to providing you with a free tool, we'll also walk you through the return on investment calculation and other essential investing concepts.
We'll also touch on the power of compounding interest and how you can use it to save money for important life events such as retirement and significant purchases. We'll also cover how to calculate ROI to help you tie all these concepts together, so let's get started.
What is Return on Investment (ROI)?
What is the ROI meaning, exactly?
It's a metric that measures the efficiency of an investment. It is calculated by taking the total return on investment and dividing it by the amount of money initially invested. ROI is most commonly used to measure the performance of financial instruments such as stocks and savings accounts. It is also popularly applied to business activities such as marketing, fundraising, and employee productivity.
The most common ROI formula for how to calculate rate of return on investment is as follows:
ROI = (Gains from Investment – Cost of Investment) / Cost of Investment
For example, if you invest $1,000 in a stock and it increases in value to $1,200, then your ROI would be ($1,200-$1,000)/1,000 = 0.2.
You can express ROI as a percentage by multiplying the ROI by 100. So in our example, the ROI would be 20%.
The ROI calculation is similar to how to derive the return on invested capital:
ROIC = (Net Income - Dividends) / (Total Assets - Non-Interest Bearing Current Liabilities)
Our investment calculator is a good start for incorporating the idea of ROI to understand the efficiency of your investments.
What is Compounding Interest?
Compounding interest is a powerful financial tool to grow savings or investments over time. It is the process of earning interest (or a return) on the interest already accumulated. This is different from simple interest, which does not include interest that has been earned in the calculation of future interest.
For example, if you put $100 into an account that pays 10% interest annually, the interest earned in the first year will be $10. If the interest compounds annually, you will earn $110 ($100 + $10) in the second year. The interest earned in the second year will be $11 x 10% = $1.10. In the third year, you will earn $12.10 ($11 + $1.10), and so on.
You can test more examples using our compound interest calculator.
Compound Interest Examples
Here are some further examples of compounding interest. Let's say you invest $10,000, which gives you 5% compounding returns over 20 years.
Here's how that future value will change when interest compounds across different timeframes. Note how an investor would benefit from compounding interest when it accrues monthly and especially daily, thus leading to a higher future value at the end of 20 years:
- Future value when interest compounds yearly: $26,532.98.
- Future value when interest compounds monthly: $27,126.40
- Future value when interest compounds daily: $27,180.96
To illustrate how powerful daily and monthly compounding interest can be, let's go with a more practical example.
If you try to grow an initial $10,000 investment to $50,000 in ten years at a 5% interest rate, this is how much you'd need to contribute each month when your returns compound daily, monthly and yearly:
- When interest compounds daily, you would need to contribute $215.59 per month.
- When interest compounds monthly, you need to contribute $215.93 per month.
- When interest compounds yearly, you need to contribute $311.50 per month.
How Do You Calculate ROI?
P(1 + r/n)nt is a formula used to calculate compound interest over a given period. Here's how you can use it for calculating compound interest step by step.
Step 1: Understand the variables in the equation.
First, understand the equation variables for the return-on-investment calculation:
- P is the principal or initial amount invested.
- r is the annual interest rate.
- n is the number of times interest compounds per year.
- t is the number of years the money stays invested.
Step 2: Convert the annual interest rate to a decimal.
To convert the annual interest rate to a decimal, divide the annual rate by 100. For example, if the annual rate is 5%, divide 5 by 100 to get 0.05.
Step 3: Calculate the compound interest rate.
The compound interest rate is calculated by adding 1 to the decimal form of the annual rate, then dividing the result by the number of times the interest compounds per year. For example, if the annual rate is 5% and the interest compounds quarterly, the compound interest rate would be (1 + 0.05/4).
Step 4: Calculate the compounded amount.
You can calculate the compounded amount by multiplying the compound interest rate by the principal and the number of years the money stays invested. For example, if:
- Principal: $1,000
- Annual rate: 5%
- Interest compounds: Quarterly
If the money stays invested for 10 years, the compounded amount would be (1 + 0.05/4)^10*$1,000.
Step 5: Calculate the total amount.
You can calculate the total amount by adding the principal to the compounded amount. For example, if:
- Principal: $1,000
- Annual rate: 5%
- Interest compounds: Quarterly
If the money stays invested for 10 years, the calculation would look like this: $1,000 + (1 + 0.05/4)^10*$1,000.
The total return would be $1,643.62.
How Do You Interpret ROI Calculations?
All else being equal, a high ROI indicates a good return on an investment, while a low ROI indicates a poor return on an investment.
When interpreting ROI, consider the investment context, including the risk associated with the investment and the potential for future growth. For instance, stocks with smaller market capitalizations and share prices, such as penny stocks, may have more upside potential in the context of stock investing. However, the risk of losing some or all of your initial investment is far higher. You can apply the same logic to growth stocks, particularly those in the rapidly changing technology sector.
To get a real sense of how large or small a company's market capitalization is, you can plug in some numbers into our market cap calculator and see instant results.
You can also use our price-to-earnings (P/E) ratio calculator to see if a company's P/E is low or high.
Something to note here when comparing the efficiency of investments: Consider an equivalent amount of risk. For example, since stocks are generally riskier and more volatile than real estate, one would expect a higher ROI investing in the former than the latter.
Also, consider comparing the ROI against investing benchmarks such as the risk-free rate and the average long-term return of a stock index like the S&P 500. If an investment of equivalent risk is underperforming one of these appropriate benchmarks, it may also fail to be a suitable investment.
Finally, ROI also doesn't consider the time value of money, so consider the time the investment took to generate a return. Investments that take a long time to produce yields are less desirable than investments that produce yields in a short time because inflation reduces the purchasing power of money over time, opportunity costs, and increased downside risk of losing your initial investment.
Consider giving our inflation calculator a try to get a broad sense of how inflation may change the return from your investments.
Examples of ROI Calculations
Here are two ROI examples and calculations taken from the world of investing.
Let's say you invested $10,000 in a stock. After one year, the stock has increased in value by 10%, and you have received a return of $1,000. The ROI of the investment would be 10%, calculated as follows:
ROI = Return / Cost
ROI = $1,000 / $10,000
ROI = 10%
In this example, a return of 10% is considered a good investment return. You've earned a higher return than the initial cost of the investment.
We can see another example of ROI in the real estate market. Let's say you purchase a property for $200,000. After one year, the property value has increased 10% and is now worth $220,000. The ROI of the investment would be 5%, calculated as follows:
ROI = Return / Cost
ROI = $20,000 / $200,000
ROI = 5%
In this example, a 5% return is still a good return on the investment, as the investor has earned a higher return than the initial cost.
How to Use the Investment Calculator
This calculator is a valuable tool to help you make investment decisions. You can use it to calculate four fields on this page: the initial amount, target amount, contributions and time invested values.
The tool's output displays to the right of the input area and above the graph. The value of your calculated field is shown in the graph's title and will appear once you hit the blue "calculate" button. Below the title, a multi-line graph shows additional values of the investment's balance, principal and accrued interest.
The tool will compute the selected calculated field for you and take care of working out the compounded interest.
Follow the step-by-step instructions below to start using it.
Step 1: Select your calculation.
To start using the calculator, select which field you'd like to calculate using the dropdown box next to the "calculate" label. This is the most critical step of the process of how to calculate return on invested capital, which will determine the calculator fields available to you.
You can calculate the initial amount, target amount, contributions and time invested fields shown on the calculator.
Step 2: Complete the fields.
Next, fill out the rest of the fields in the calculator. Assuming we want to calculate the "initial amount" field, we'd start by declaring our "targeted amount" and then work our way down to the "contributions" field. Note that you can set contributions monthly or yearly.
Once you complete these steps, we'll move on to the "time invested" field. Using the dropdown box, you can select from months or years. Finally, choose your interest rate percentage and whether interest compounds monthly or yearly. Once you're ready to see the results, click the "calculate" button.
Step 3: Analyze your results.
Once you hit the "calculate" button, your calculation will appear in the graph's title, as seen in the example below. Other values for the investment's balance, principal, and interest will also appear as part of the multi-line chart.
Benefits of ROI
The benefits of ROI include the following:
- Greatest growth potential: ROI allows investors to identify stocks with the greatest growth potential.
- Ballpark gains: The formula assists in the decision-making process by indicating how much you can expect to gain in relation to the amount invested.
- Consistent returns: ROI calculations help create a portfolio of stocks with a higher likelihood of providing consistent returns.
- Compares performance: ROI calculations help compare the performance of different portfolio stocks and identify underperforming stocks.
- Helps determine timing: You can use it to determine the best time to enter or exit a stock position.
- Evaluate strategy: You can use it to evaluate the success of an existing stock strategy.
Limitations of ROI
On the other hand, consider some limitations of ROI:
- Time/value of money not considered: ROI does not consider the time/value of money, which is the idea that money invested today is worth more than money invested tomorrow.
- May not accurately reflect risk: ROI may not accurately reflect the risk associated with the investment.
- Cost of capital: ROI does not consider the cost of capital, which is the cost of borrowing money to invest.
- Liquidity: It does not consider the liquidity of the investment, which is an important factor for investors.
- Does not account for taxes: ROI does not account for taxes, which can significantly reduce the amount of money an investor receives.
- Opportunity cost not considered: It does not consider the opportunity cost of investing capital in one stock over another.
- Does not consider volatility: ROI does not consider the volatility of the market, which can affect the value of investments over time.
Alternatives to ROI
You can use several alternative methods to ROI to measure the success of an investment or project, including net present value (NPV), internal rate of return, payback period, cost-benefit analysis and economic value added.
- Net present value (NPV): NPV is a measure of the relative profitability of a project. It considers the project's cost, the expected future cash flows and the time value of money.
- Internal rate of return (IRR): IRR measures the return earned by an investment or project. It considers the project's cost, the expected future cash flows and the time value of money.
- Payback period: The payback period measures the time it takes for an investment or project to return its initial cost.
- Cost-benefit analysis: Cost-benefit analysis is a method used to assess a project's potential in terms of its benefits compared to cost.
- Economic value added (EVA): EVA measures a project's potential in terms of its ability to generate value for shareholders.
ROI: A Vital Concept for Investors
It's vital to recognize ROI and understand the broad strokes of its use. Although it may lack nuance, it is also invaluable for getting a high-level overview of the efficiency of an investment and its performance, all else being equal.