Return on Investment (ROI)

A widely used financial metric that measures an investment's profitability by measuring the investment relative to its cost.

David Bickerton

Reviewed by

David Bickerton

Expertise: Asset Management | Financial Analysis


September 5, 2023

What Is Return On Investment (ROI)?

Return on investment is a widely used financial metric that measures an investment's profitability by measuring the investment relative to its cost.

Return on Investment or ROI can be very useful when comparing the success of different investments to understand which projects were the most economically efficient.

To calculate ROI, you divide the Return on the investment by the cost of the investment.

ROI = Return on Investment / Cost of Investment

One of the main reasons finance professionals use the ROI metric is to compare various investment opportunities and to rank them according to risk and Return.

This metric is popular because of its straightforwardness and applicability to any investment. Whether it is an investment in the stock market or opening up a new restaurant, ROI can be applied.

A positive ROI will indicate that this investment is economically efficient, and a gain will be received from this transaction. 

However, if the ROI is negative, it can signal that there is a better alternative for investments that an investor can undertake, which will result in a gain.

Key Takeaways

  • Return on Investment (ROI) is a widely used financial metric that measures the profitability of an investment by comparing the return generated to the cost of the investment. It's expressed as a percentage.
  • A positive ROI will indicate an economically efficient investment. Still, it’s not necessarily the better one.
  • The concept of a return on investment is linked to risk; the riskier a project is, the more return you expect to receive as a payoff for the extra risk.
  • Taking a project with high risk and a small ROI, even positive, can be an extremely bad decision for the company. Since the company is not being reimbursed properly for the risk it has taken.

Return on Investment Example

We will look into some examples of how to calculate the ROI.

Assume you invested in the stock market in a company called ABC. One ABC share costs 100$, and after one year, you sell the ABC share for 150$.

ROI = 50$ / 100$ = 0.5 or 50%. 

Your Return on investment is 50%. This is an economically efficient investment since we have a positive ROI.

Examples like the investment in ABC stock above expose some limitations of using ROI, especially when comparing various investment opportunities.

Investing in a project is an extremely complex decision, and the ROI doesn’t consider that the profitability of an investment is hugely affected by other factors, including taxes and interest, fixed costs, etc.


 ROI fails to account for the time value of money, which indicates a dollar tomorrow is worth more than a dollar today because you can invest this dollar and earn interest.

Some investments will take longer to generate positive cash flows than others. However, that doesn't mean that they are bad investments.

That's one of the main reasons investment professionals use other arts like NPV or IRR to value investment decisions more efficiently and in detail.

Return on Investment Limitations

Numerous limitations arise when using the return on investment (ROI) metric to evaluate the profitability of an investment.

Some of the limitations include the following:

1. ROI ignores the timing of the cash flows of the project

The metric only considers the net gain of the investment or project and doesn't consider when the cash flows occur. Therefore, it makes comparing investments with different horizons harder.

2. The metric does not consider the investment's level of risk

This can make it harder to compare projects with different risk levels.

3. It fails to consider the potential for future growth

ROI is solely based on past performance and doesn't consider the potential growth an investment or project can make, limiting the comparison between businesses with different growth potentials. 


Keep in mind that despite these limitations, the ROI metric is still used widely in evaluating investments. However, it is crucial to consider other metrics along with the ROI, like NPV or IRR.

Factors determining a good ROI

A specific return on investment is not considered good, as the appropriate level of return will vary depending on the circumstances of the investor's risk tolerance and goals

However, a few factors can facilitate helping the investor in determining what a good ROI is:

1. The level of risk 

Risk and return are correlated, meaning investors who invest in riskier projects will expect a higher return as a payoff for taking on some additional risk. Resulting in a trade-off that states that the potential return increases with an increase in risk.  

For example, fixed-income investments are considered less risky than stocks. As a result, the return on stocks is usually higher than on bonds

2. The investor's goals 

Determining their goals and time horizon is essential since the return will depend on them. For instance, an investor who is risk tolerant might be willing to accept a higher risk in exchange for a higher level of risk. 

On the contrary, an investor saving for retirement might accept a lower return for a lower level of risk. 

3. Historical Return 

Luckily, a huge amount of data is available to check various asset classes' historical returns, which can be crucial for evaluating the potential return on investment. 

Historical data suggests stocks are more volatile than bonds. However, stocks have higher returns. 


The main idea is to think there is a trade-off between risk and return. The higher the risk, the higher the return, and investors will demand to take on the extra risk.

Practical Tips for using the ROI metric

Comparing an investment’s return on investment (ROI) to other comparable returns of various investments can help us make a better decision. 

This can help us determine if the business or investment is performing better or worse than similar businesses in the industry.

There are helpful ways to compare the return on investment of a business to its competitors:

1. Compare industry averages

Comparing the ROI of an investment to industry averages can give you perspective on how your investment is doing compared to its peers. This strategy is particularly helpful when evaluating an investment in a specific industry.

2. Compare to a benchmark index.

Comparing the investment to a benchmark index is extremely useful; a great example is the S&P 500 for stocks to see how the investment compares to the overall market. 

3. Compared to the investor’s portfolio

Usually, suppose the investor owns a diversified portfolio. In that case, they can compare the return on investment of the specific project to the overall rerun of their portfolio to evaluate the investment’s performance. 


Comparing the ROI of an investment across its competitors is only a factor to consider. Again, understanding factors such as the trade-off between risk and return, investors' goals and horizons, and other factors should always be considered.

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 Researched and Authored by Mohammad Ezzeddine

Reviewed & Edited by Ankit Sinha LinkedIn

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