ROI: How to calculate, interpret and use it
ROI, or Return on Investment, is a term widely used in the financial and business worlds, but its meaning is not always clear. This indicator measures the profitability of an investment, enabling you to assess whether the return justifies the amount of capital invested. But can we calculate it accurately? What constitutes a ‘good’ ROI? How can we avoid common mistakes when using it?
This article covers everything you need to know about ROI, including how to calculate it and how to interpret it in different contexts, as well as its role in financial and strategic decision-making. By comparing the return on investment (ROI) with reference interest rates, such as those for bank deposits, loans or opportunity costs, you can determine whether an investment is more advantageous than safer or more affordable alternatives.
What is ROI, and how is it calculated?
Return on Investment (ROI) is a key indicator used to evaluate the profitability of an investment. When expressed as a percentage, ROI shows the profit (or loss) made in relation to the initial investment. This makes it possible to compare the efficiency of different investment opportunities.
Formula for calculating ROI:
ROI = [(Investment Gain – Investment Cost) / Investment Cost] × 100
For example, imagine that you invest €50,000 in an asset which subsequently increased in value to €60,000. The calculation would be as follows:
ROI = [(60,000 – 50,000) / 50,000] × 100 = 20%
This result shows that the investment generated a return of 20%, equivalent to a profit of €10,000. ROI is a valuable tool for analysing the performance of investments and identifying those that offer the greatest value for money.
What is the purpose of ROI?
ROI is a decision-making tool. By evaluating this indicator, it is possible to determine whether an investment is generating value and optimising the allocation of capital. The main advantages are:
Comparing investments objectively
ROI enables you to compare various assets and investment strategies, including shares, investment funds and private equity. When investments with similar risk profiles and time horizons have different ROIs, it is clear which is the most profitable. This helps you to make informed decisions.
Measuring the efficiency of invested capital
A positive return does not necessarily mean that an investment is good. If capital remains invested for long periods with only modest gains, its efficiency may be called into question. ROI helps assess the adequacy of performance and in identifying opportunities for improvement, whether through diversification or portfolio restructuring.
Supporting strategic decisions
A consistently high ROI is a sign that an investment should be continued, whereas a return that falls short of expectations suggests that the strategy needs to be re-evaluated. Although it should not be used solely, ROI can be used as a starting point when deciding whether to maintain, reinforce or divest an asset.
Limitations to ROI
ROI is a key indicator, but focusing solely on it might result in misleading conclusions. Find out about the main precautions to take:
It does not reflect the level of risk involved
If you focus only on ROI without assessing risk, you might make the wrong decisions. Although high returns can be tempting, it is not always wise to invest in assets that are highly volatile or liquid. To gain a more complete picture, it is essential to complement ROI with metrics such as the Sharpe ratio, which adjusts returns for risk, and the consistency of earnings over time.
It doesn’t take the time factor into account
The information provided by a ROI of 20% is incomplete without the relevant time context. How long did it take to achieve it? Was it a year, five years or ten years? The time horizon is important when it comes to assessing the sustainability of returns and comparing opportunities. In addition, the ROI method does not take inflation or opportunity cost into account, which can affect the efficiency of financial decisions.
Difficulty in comparing sectors
The definition of a ‘good’ ROI can vary significantly between sectors. For example, in real estate, an annual return of 7% might be considered good, whereas in private equity investors typically expect returns of between 15% and 25% due to the increased risk involved. Therefore, it is important to consider these differences when comparing investments in different areas, otherwise the results may be misleading.
What’s the difference between ROI and profitability?
Although they are often confused with each other, ROI and profitability are different metrics. Understanding this difference is important for making rigorous investment evaluations.
• ROI (Return on Investment): Measures the total return on an investment in relation to the capital invested, expressed as a percentage. It does not take into account the time needed to achieve this return. For example, an ROI of 50% could be achieved in either six months or six years, making direct comparisons difficult.
• Profitability: Calculates the annual return on an investment, taking the time factor into account. This is expressed on an annual basis, which enables fairer comparisons to be made between options and is particularly useful when making for long-term decisions.
To determine whether an investment has outperformed a term deposit offering 3%per year, for example, you need to convert the ROI into an equivalent annual rate. Alternatively, you can use metrics such as the CAGR (Compound Annual Growth Rate) or the IRR (Internal Rate of Return), which already take the time factor into account.
How can you use ROI?
When it comes to evaluating investments, the Return on Investment (ROI) is often the first indicator considered, thanks to the simplicity and clarity it brings to the process. However, it rarely provides a complete analysis on its own. Other financial KPIs, such as CAGR, IRR, Payback and NPV, offer more detailed insights, particularly when time or variable cash flows are involved.
ROI is measured as a percentage of the total return on an investment. It is a useful way of quickly determining whether a profit or loss has been made in relation to the capital invested.
• Calculation formula: ROI = [(Gain - Cost) / Cost] × 10
• Suitable for: Quick evaluations of profitability, such as campaigns or one-off investments.
• Benefits: Easy to calculate and compare directly.
• Limitations: It does not take the time factor and the value of money into account, and can be misleading if used on its own.
What is a good ROI?
The definition of a "good” ROI varies depending on the sector, the level of risk and the investment time horizon. Below, we present benchmarks for different asset classes:
Real Estate
In the real estate sector, an annual ROI of between 5% and 10% is generally considered attractive. Properties in strategic locations can exceed these figures. Meanwhile, mature markets such as the housing market offer more moderate but stable returns.
Shares
On average, the stock market has achieved average annual returns between 7% and 12%, adjusted for inflation. These figures can vary depending on the sector and market volatility. While high-growth companies can offer higher ROIs, they are also more exposed to risk.
Private equity funds
Private equity investments have achieved annual returns of between 15% and 25% in the past, but they require a long-term outlook and lower liquidity. The potential for high earnings is coupled with considerable risks and a longer time commitment.
Startups and venture capital
Investing in startups or venture capital typically aims for a ROI of over 30%, but comes with a high failure rate. Only a small proportion of projects achieve significant valuations, making them suitable only for investors with a high risk tolerance.
Bonds and fixed-income instruments
Historically, more conservative investments, such as government and corporate bonds, have offered annual ROIs of between 2% and 6%, depending on the term and issuer. These are ideal for those who prioritise stability and capital preservation, even if this means accepting more modest returns.
Crypto and digital assets
The cryptocurrency market has generated exceptional returns on investment (ROI) in recent years, with some investments exceeding 100% in a single year. However, it also involves significant losses and its track record is limited. Such extreme volatility requires close monitoring and a cautious approach.
Maximise your ROI with expert guidance
To evaluate ROI (return on investment), you need a comprehensive understanding of the market, detailed asset analysis and a strategy that aligns with your financial objectives. At Banco Carregosa, our team of specialists will support you in identifying the best opportunities and building a balanced portfolio that optimises returns while safeguarding your assets.
Contact us if you want to maximise your investments and ensure your capital is used efficiently. Together, we’ll develop the perfect strategies to maximise your ROI while maintaining financial stability.