Return on investment, or ROI, measures how well your investment is performing. There are different ways to measure it: as a raw dollar amount, a total percentage, or the average annual return. The raw-dollar-amount ROI is useful for knowing how much money you made on the deal, but it doesn't tell you how much you made in relation to your investment. For example, nobody's going to turn down $1,000, but if you had to invest $100,000, you're probably better off investing elsewhere. The total percentage return is better, but it doesn't tell you how long it took you to earn the return. For example, while a 25-percent return sounds great, if it takes you a decade to make that much, you might want to park your money elsewhere. To illustrate how the different ROI formulas work, it's easiest to use a hypothetical investment to run through the formulas.
Make up a hypothetical investment with a purchase price, selling price and the amount of time you held the investment. For example, imagine a stock that you buy for $1,000, hold for four years and then sell for $1,600.
Calculate the raw return on investment by subtracting the purchase price from the selling price. In this hypothetical, subtract the $1,000 purchase price from the $1,600 selling price to find the raw return is $600.
Divide the raw return by the purchase price to figure the hypothetical total percentage return on investment. In this example, divide $600 by $1,000 to get 0.6, or a 60-percent total return.
Add 1 to the result as the first step to figuring the average annual return. In this example, add 1 to 0.6 to get 1.6.
Raise the result to the power of 1/Y, where Y is the number of years you held the investment. Here, since you held it for four years, raise 1.6 to the 1/4 power to get 1.1247. On a calculator, the power button is usually "^" or "x^y." So, you would enter "1.6," push the power button, then open parenthesis button --"(," then "1," then the division sign, then the number of years, then the close parenthesis button -- ")," and finally enter or equals.
Subtract 1 from the result to find the average annual return. Finishing up the illustration, subtract 1 from 1.1247 to get 0.1247. This means the stock increased by an average of 12.47 percent each year over the four years.
- ROI isn't limited to stocks -- you can use it for just about any investment such as mutual funds, certificates of deposit or land.
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