How to calculate ROI
ROI (Return on Investment) measures how much an investment earned relative to what was put in. It's the most common metric for comparing the profitability of different investments, marketing campaigns, or projects, regardless of the absolute amounts involved.
Formulas used
ROI: ROI (%) = (return value − initial investment) ÷ initial investment × 100
Net profit: profit = return value − initial investment
Annualized ROI: annual ROI (%) = ((1 + ROI ÷ 100) ^ (12 ÷ months) − 1) × 100
Required return value: return value = initial investment × (1 + target ROI ÷ 100)
Practical example
If you invested $1,000 and got back $1,500, the net profit was $500 and the ROI was 50%, calculated as (1,500 − 1,000) ÷ 1,000 × 100. If that result took 18 months, the annualized ROI comes out to roughly 31.6% per year, which helps you compare that investment to another that returned, say, 25% over 12 months.
Why annualize ROI
Comparing two investments by raw ROI alone can be misleading when the holding periods differ. A 40% ROI over 3 years is actually more modest than a 15% ROI over 6 months, even though the second number looks smaller at first glance. Annualizing ROI puts both investments on the same footing: how much the money earned per year.
ROI is not the same as net profit
Net profit is an absolute dollar amount and says nothing about the size of the investment that generated it. ROI is a ratio, which is why it lets you compare a $1,000 investment with a $1,000,000 one on equal terms. A $10,000 profit can be excellent on a $20,000 investment (50% ROI) or negligible on a $2,000,000 one (0.5% ROI).
Limitations of ROI
ROI on its own doesn't account for time (that's what the annualized version is for), the risk taken on, or indirect costs that sometimes don't make it into the calculation, like taxes, maintenance fees, or the opportunity cost of putting the money elsewhere. Use ROI as a first-pass filter for comparison, but weigh timeframe and risk too before deciding.