What does ROI mean and how does it affect the investment decisions that you make? The full name of this term is “Return On Investment,” and this is an important figure that shows you the chances of making a profit from a particular investment. Once you understand the ROI definition, you will be able to make more informed decisions.
You can also use the profitability ratios from this calculation to compare different investments and see which one is likely to be the best for you. Let’s take a look at how to calculate ROI and how knowing this figure helps you.
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What is ROI?
What is return on investment and how does it help you to make better investment choices? There is no single way to assess which investment is best, especially when you compare different types of investment. However, the rate of return on investment is a useful way of seeing how well an investment performs over time. It is a number that shows how much profit you should hope to receive on the initial amount invested.
While this is a general term that is widely used in the investment world, there are a number of different ways of looking at how to work it out. This means that it can be confusing at first, as you try to work out which investment is going to be most profitable for you.
You might also see the term Rate of Return (ROR) used. If we look at return on investment vs rate of return, we can see that it is essentially the same thing. If you see the rate of return on investment listed, then you are looking at the ROI figure.
Basic formula to calculate return on investment
Working out the ROI is pretty simple, so you don’t need an ROI calculator or any other special tool to do it. For an investment, the simplest way to calculate this figure is with the following formula: ROI = Investment Gain / Cost of Investment x 100.
A look at how to work out a return on investment in the property market gives us a clear example of how this works. Let’s say that you buy a property for £200,000 and then sell it at a price of £400,000. This gives a calculation of 400,000 – 200,000 / 200,000 x 100 = a 100% return, which basically means that you have doubled your money.
A more complicated example could be where you buy shares for £500 and later sell them for £725. In this case, the ROI formula is 725 – 500 / 500 x 100, which comes out as a 45% return on investment.
What does ROI stand for when it is negative? A negative ROI is possible if the investment loses value. We use the same ROI calculation formula, so if you paid £1,000 and ended up with £950, the calculation is as follows; 950 – 1,000 / 950 x 100 = -5.2%.
It is worth noting that the generally accepted return on investment formula doesn’t take into account the length of time you have held the investment for. In that first example, you have made a 100% ROI regardless of whether you owned the property for six months or for a couple of decades. You need to look at the timescale and decide whether the stated return is good enough taking this into account. Especially if you consider inflation.
As we have seen, this is a fairly simple calculation that should only take a moment to work out. You can probably work this out quickly in most cases without any need for a return on investment calculator, and which will allow you to make better, faster decisions about the investments you take on.
What is a good return on investment?
Having looked at how to calculate the ROI for an investment, we now need to consider and ask the question: “What is a good return on investment anyway?” There is no point in knowing how to work out the ROI if you then don’t know how to interpret it.
The truth is that there isn’t a single answer that tells us what the best return of investment should look like. What looks good to one person might not be as tempting to another. Therefore, we need to take into account the factors that are involved in any financial decision.
Your financial needs
Your financial needs depend, among other things, on at what stage you are in life. For example, someone who is just starting their career and making their first investment, will have different goals from someone in mid-life who has a family to support or a recent retiree who is looking to live comfortably using their assets.
These factors will help determine what type of investment each person feels is right for them, and the sort of average return on investment they would be happy with.
The risk level
The risk involved in the investment is also something to consider together with the ROI. If you feel that an investment is fairly risky, it makes sense that you would be hoping to see a high potential ROI for it.
The lowest-risk investments, such as government bonds, tend to come with a fairly modest return. This is acceptable to some investors as they prioritise the idea of keeping their money safe over the amount they can earn from it.
With riskier investments, such as small-cap stocks held for a long period, the fact that there is a higher level of risk means that you would tend to look for a higher ROI to justify making this kind of investment. You need to consider which risk level you are comfortable with when looking at what ROI is, and how much you want to aim for.
Risk & returns on eToro
When you look to build an investment portfolio, the link between risk and ROI that we just looked at should be high in your thoughts. How to get maximum return on investment without being exposed to unnecessary risks is the key question to look at here.
The risk score on eToro is a vital tool in this respect. It allows users to look at the risk rating of Popular Investors before copying them with the CopyTrader feature. Here, you can look at the monthly and yearly returns achieved overall and on each of the different instruments that they’ve invested in.
A look at their P/L (profit or loss) reveals the average profit or loss that they have made on their trades, giving you another way to see whether this is an investor you would be happy to copy. This is one way to invest without pushing up the risk levels more than you are comfortable with.
You will want to check the current fees before making any sort of investment, as this will affect the final profit that you can achieve. In this respect, the eToro fees section is very clear about the fact that opening an account is free, there is 0% commission on stocks and no management fees are charged.
Types of Returns
With any financial asset, there are two possible types of return that you could receive: dividends and capital gain. In some cases, it may not be entirely clear at first glance which of these returns you will get, or what the combined total could be if both are possible on the same investment.
For example, some stock indices report the price appreciation, but don’t give an accurate reflection of the adjustment for the dividend payment. The total return is the combination of dividend and capital gain, but you won’t always see this figure right away. In the same way, we also need to take care over the period in which the return is noted, as it may be annualised or not.
This section covers those assets that give you a return in the form of dividends or interest payments. A lot of investors neglect to take this type of return into account, as they prefer to look at whether the price of the share has gone up or down in recent times.
Bear in mind that the company is giving its shareholders part of its value when it pays out a dividend. This means that the price of dividend stocks is lower than it would otherwise have been, had they decided to hold on to the money rather than paying a dividend. Therefore, it is important that you add dividends to the total return figures.
You will also see some financial assets that don’t pay dividends, meaning that you work out the return based solely on the capital appreciation as the price of the asset changes. This is the case in stocks that don’t pay any dividends, such as Google and Apple, but that could still provide the best return on investment potential.
Assets such as bonds and pension plans only provide income in the form of payments, rather than increasing in value. The best dividend stocks could give you regular payments as well as rising in value over time.
Dividends on eToro
Does eToro pay dividends? Yes, dividends are paid on eToro on those instruments that can earn them. The following are assets that can earn you dividends:
- Dividend stocks. High dividend stocks may be paid out annually, every six months or quarterly.
- Dividend ETFs, like this Vanguard S&P 500 ETF dividend option (VOO) also allow earning dividends. Not all shares include dividends, so be sure to check for stocks that pay dividends if you are interested in receiving regular payments. Do ETFs pay dividends in every case? No, you need to look for a specific high dividend ETF like the one mentioned above.
- Real assets.
When are dividends paid out on eToro? With CFDs, investors receive a dividend on the ex-dividend date, which is the Date of Record. With real assets, you need to have held the position before the market closes, two days before the ex-dividend date is reached. The dividends that you receive may be taxed, depending on the country where you are resident.
The next point to consider is how to check your eToro dividends. This is done in the following way.
- Go to Pportfolio and then choose the clock icon.
- Select the time frame that you are interested in checking.
- Tap on the gear icon and choose Aaccount Sstatement.
- You can now pick the start date and end date.
- The next step is to download the excel file with the statement.
- View the transactions report sheet.
- You will now see any payments relating to dividends.
How are dividends paid on eToro? This cash is automatically added to your account on the date it is due.
Reaches and limitations of the basic ROI formula
There are certainly some reasons for working out the possible return on investment using the basic ROI formula that we looked at earlier. Yet, there are also some drawbacks that you should be aware of before you do this.
- This is an easy-to-use metric that you can work out very quickly and understand right away.
- This metric can provide an at-a-glance point of comparison between investments.
- Businesses may often use this as a way to measure their own performance, so using ROI to evaluate an investment may align with a business’ internal metric of success.
- This type of quick ROI analysis doesn’t take into account how long the investment is held for. This can be an issue when you want to compare different types of investment. To overcome this matter, you can use an annualized ROI formula with the holding period return (HPR) calculation. The formula is income + (final value – initial value) / initial value. This is then divided by the number of years it has been held for, to give an annualized figure.
- There is no risk adjustment in this sort of basic ROI calculation.
- All of the expected costs need to be included to make the figure as accurate as possible. Leaving out the costs exaggerates the ROI analysis results, whether it is done on purpose or inadvertently.
- The ROI figure looks purely at financial gains and doesn’t let us understand other benefits such as social or environmental factors. The social return on investment (SROI) can be used to let us see the social value generated for each dollar invested, and is usually shown as a ratio.
Other Alternatives to the ROI formula
While the main ROI formula and the general ROI meaning is the most common approach for assessing investments, we can also look at how to calculate return on investment in other ways.
Return on Assets (ROA)
What is ROA and how can it be used to assess an investment? Return on Assets (ROA) is a profitability ratio that shows you how much a company can generate from all of its current assets. It is a way of seeing whether the business has proved to be efficient in how they make their assets and resources turn into income. We can calculate return to asset ratios and express them as a percentage by using the following ROA calculation; ROA = net income / average total assets.
How can you calculate ROA correctly?
This return on assets formula uses average assets because it is a figure that can vary widely from one moment to another. So, we can work out a company’s assets from the balance sheet over two or more years and calculate a return on assets ratio.
Example: Let’s say that their average assets are £100 million (£80 million one year and £120 million the next year) and their income £5 million. The ROA formula of 5 / 100 gives us a ROA of 5%.
Generally speaking, the higher the return on assets ratio the better, but you might want to look at an industry benchmark to see how it stacks up against competitors.
Return on Equity (ROE)
What is return on equity and how can it help to give you a different view of a possible investment? The return on equity formula is another useful way of measuring a company’s financial performance. In this case, we reach a figure that shows the return on equity ratio by dividing the company’s net income by shareholder’s equity. This gives us an indication of its profitability in relation to stockholder equity, which is the same as their assets less their debt.
Net income and equity both need to be positive for this return on equity calculator to work. ROA = net income / average shareholder’s equity over a period. You would normally look for this figure to be greater than 10%, but the return on equity ratio varies greatly by industry. This figure helps us to see if a company is growing sustainably or if its profits are inconsistent or its debt levels are high.
Example: This company has an income of £10 million and shareholders’ equity of £40 million. What is ROE in this case? The ROE formula gives us a figure of 25%, which appears strong, but would be considered on the high side in most industries, so you would probably look to dig a little deeper in terms of their peers’ performance and see how to calculate return on equity for them to carry out a full return on equity ratio analysis.
Internal Rate of Return (IRR)
What is IRR and what information does it give us? The IRR formula is a type of discounted cash flow analysis that is carried out by making the net present value of all cash flow zero. This gives a return ratio, and the higher this rate, the more attractive the potential investment looks. This is because the IRR calculator tells us an expected annual growth for the investment.
The internal rate of return formula is more complex than in the other calculations we looked at earlier. You will probably want to work it out on an Excel internal rate of return calculator using the formulae IRR, XIRR, and MIRR to see the profitability ratios worked out instantly.
Having looked at the ROI and different ROI calculators, it is clear that this is an extremely useful way of looking at the potential return you could expect from an investment. By understanding what a good ROI is and being able to assess the relevant numbers, you can quickly get an idea of whether it is an investment worth making.
Knowing how to calculate ROI gives you a way to see how to get maximum return on an investment by taking some of the key factors into account. Users of eToro can easily understand the returns available without having to carry out complex ROI calculations.
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This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.