Return on investment (ROI)

Before you rely on it

What to check

State the denominator and the time period.

The common error

Where people go wrong with return on investment (ROI)

Comparing an ROI with no horizon against an annual rate. A 40% return is excellent over one year and poor over ten.

Worked through

Return on investment (ROI) in plain numbers

You invest $20,000 in a small project and it returns $23,000; the net gain is $3,000, and ROI is $3,000 ÷ $20,000, or 15%. That says nothing about time. If it took three years, the annualized return is about 4.8%, from 1.15 raised to the power of one third, minus one. If it took six months, the annualized equivalent is far higher. Costs matter as well: if you also spent $1,500 of your own time and expenses that you did not count, the net gain is smaller and ROI falls to 7.5%. ROI depends on what is in the numerator and denominator.

Easily confused

Return on investment (ROI) and its neighbours

ROI is not IRR, ROAS or profit margin. ROI is a simple ratio of net gain to investment cost, with no timing. IRR handles cash flows at different dates. ROAS compares revenue with ad spend. Profit margin compares profit with revenue. ROI can be defined in different ways, using total costs or only cash outlay, so two people can report different numbers for the same project. Payback period says how long recovery takes. Ask what is counted before comparing.

In real decisions

Where return on investment (ROI) turns up

Businesses use ROI to compare investments in equipment, marketing, training or software; investors use it for a quick sense of a holding's result. Homeowners use it to judge improvements, though resale value is only part of the story. Freelancers use it to decide whether a course or tool is worth the money; it is the most common way to state a return, because it is simple to compute and explain.

Know the edges

Where return on investment (ROI) stops being reliable

It ignores the length of time and the risk, so a high ROI over ten years may be poor; it depends on what is included as cost and benefit, and benefits are often hard to measure. It cannot compare projects of different lengths without annualizing. Use it with NPV or IRR for larger decisions, and state your assumptions.

Quick answers

What people ask about return on investment (ROI)

Does ROI include time? No. A 20% ROI over one year and over ten years look the same. Annualize it to compare.

What should count as cost? All money and time you put in, including fees, taxes and your own labor if you want an economic view. State what you include.

Is ROI the same as profit margin? No. Margin divides profit by revenue. ROI divides gain by the amount invested.