What is ‘Return on investment’?
Return on investment is the performance measure to valuate a company fundamentally. This is usually known as ‘ROI’. ROI is the percentage return on investment in terms of profit or loss. Percentage is the unit of ROI.
Usually companies with high ROI represents high performance and prosperity of the company. ROI is the one best performance measure in terms of fundamental analysis for long term investors.
Simplicity of the ROI make it as very popular measure. Since calculation of ROI is simple and straightforward. Essentially ROI helps to know the past performance of the company. If ROI is negative which represents the bad investment. Although companies with negative ROI are running under losses.
For example John invested ₹10,000 in some company, in 2010 and sold all the shares for ₹13,000. In order to calculate his ROI on his investment, he should divide his earnings ( ₹13,000 – ₹10,000 = ₹3000 ) by the investment cost of ₹10,000, therefore ROI of ₹3000 / ₹10,000 or 30%.
Accordingly he can compare his investment with other investments, then he can select best among them. Duration for ROI is commonly 3Months, 6Months, 1Year, 3Years and 5Years, Rarely 10Years.
Although only ROI is not sufficient for investors to gauge a profitable company, since it only represents past performance in terms of profit. It fails to depict the flow of cash, debt, assets and liabilities. Consider the above example, in john’s case there is no time constrain. He got 30% returns, question rises, what is the duration.
Finally ROI can be helpful to co-relate with different companies with the almost identical fundamentals.
Formula for ROI
ROI = ( Profit from Investment – Price of investment ) / Cost of investment
Limitations of ROI
- Time is not the constrain here.
- There is no space for reinvestment.
- Not suitable for fundamental analysis.
- There is no scope for intrinsic of book value of the company.