Return on Investment: What It Is & Why It's Important

To effectively evaluate any type of investment, it is important to first understand your return on investment (ROI). This understanding serves as the baseline for all informed investment decisions. While the calculation remains constant, there are unique variables that different types of investments bring to the equation.

The formal definition of ROI is a performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments.  Return on investment is a very popular metric because of its versatility and simplicity.

To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.

In this formula, "gain from investment" refers to the proceeds obtained from selling the investment of interest. That is, if an investment does not have a positive ROI, or if there are other opportunities with a higher ROI, then the investment should be re-evaluated.

ROI is a simple calculation that tells you the bottom line return of any investment. The watchword here is simple. One major factor that doesn't appear in an ROI calculation is time. Imagine investment A with an ROI of 1,000% and investment B with an ROI of 50%. Easy call – put your money in the 1,000% one. But, what if Investment 1 takes 30 years to pay off and Investment 2 pays off in a month? This is when time periods come into play and investors must look to Compound Annual Growth Rate, or CAGR.

ROI is a useful starting point for sizing up any investment. Remember that ROI is a historical measure, meaning it calculates all the past returns. An investment can do very well in the past and still falter in the future. This scenario is called marginal increase. For example, many stocks can yield ROIs of 200-500% during their growth stage and then fall down to the single digits as they mature. If you invested late based on the historical ROI, you will be disappointed. Projected or expected ROIs on new, unproven investments are naturally more uncertain, since little or no historical data is available to perform forecasts.

Determining the ROI for technology benefits is a less straight-forward matter. Here are some links that look at the variables and metrics one should evaluate to make an accurate assessment:

Calculating ROI for Technology Investments

Six Measures for Assessing Technology ROI

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