What Does an ROI Analysis Measure and What Are Its Advantages?
Investments often have the possibility to offer high rewards to investors. Understanding how to calculate ROI, or return on investment, can help you determine the probability of a return on your initial investment. In this article, we show you what ROI analysis is, what it measures, what its advantages and disadvantages are and how you can calculate it.
What is an ROI analysis?
An ROI analysis is a study of the probability of an investment vehicle producing a return. A return is any gains the investor sees as a result of investing their capital. For example, if an investor helps a startup get established with $100,000 in capital, the investor might gain 10,000 company shares. As the company grows, those shares might increase in price, which creates gains for the investor.
What does an ROI analysis measure?
An ROI analysis considers several factors, including:
The company or asset's performance
An ROI analysis analyzes a company or asset's performance over a specific period of time to determine its potential profitability. For example, an investor might measure the growth of a particular cryptocurrency over the year to determine if it's a good time to invest in it. This helps investors time investments for the best possible returns by learning if the asset performs better at certain times of the year, during certain economic periods or under certain market conditions.
The overall market sentiment
When making investments in the stock, crypto or futures markets, investors typically look at market sentiment as an important part of calculating the ROI. If the market sentiment is positive and set for growth, it can be a good time to invest. The market sentiment of an asset or a business describes how investors view or feel about the market. If there is a generally positive attitude toward a particular market or asset, it could be a good investment as more investors stake capital.
Net income and assets
Investors also look at a company's net income and the value of its assets to determine profitability. This includes the amount of debt the company holds, its operating costs and any other costs for running the business. A company with valuable assets and high net income might be a good choice for investors looking for better returns.
What are the advantages of ROI analysis?
Performing an ROI analysis offers many advantages for potential or current investors, including:
The health of a business or asset
An ROI analysis of a company or asset can provide the investor with a better understanding of the overall health of the business. Because the investor is investigating factors like market sentiments, net income, assets, debts and asset performance, they can learn more about the company's overall health. For example, an investor might learn that a technology company creates historic returns of nearly 9% annually, but the internal structure of the company lacks the leadership to guide it to a profitable future.
Understanding the ROI of a business or asset can provide a more complete image of the company's health so investors can more accurately ensure their money creates the best returns on their investments.
Related: What Is Investment Management?
An ROI analysis can help an investor learn more about the company's leadership and its qualifications within the industry. Because the company's leaders play a significant role in the success of the business, the investor might want to know more about their experience, education and industry-specific skills before making an investment decision. A company with good leadership and fundamentals can create better returns for the investor as the company grows.
Thorough comparative analysis of other assets
An ROI analysis can help an investor perform a more thorough comparative analysis of similar assets or companies, thus gaining better insight into the market or industry. Typically, investors compare competitors to determine which offers better ROI and profitability.
For example, an investor putting capital into artificial intelligence companies might look at the top three AI brands on the market to determine which produces the better product. This might be the more profitable option.
What are the disadvantages of the ROI analysis?
While an ROI analysis is a useful financial tool, it does have some disadvantages. These can include:
Inaccurate results: The ROI analysis is an estimate, not an exact measurement. Investors can overcome this issue by using ROI analysis as a template instead of a definitive investment strategy.
Lower diversity in investments: ROI analyses may create a lack of diversity in investments, as investors look for companies with only historically high ROIs. To prevent this, investors can consult with financial advisors for guidance and perform better research into different companies or assets.
Differences in company policies: Not all companies follow the same accounting practices or measure investments the same way. To navigate this, investors can research company policies and ensure the company follows traditional investment practices.
How can you calculate an ROI analysis?
Calculating an ROI analysis can help you create an estimate for a particular business or asset's potential profitability should you invest capital into it. Here's how to calculate an ROI analysis:
1. Choose a formula
Typically, there are two different formulas that an investor can use to calculate ROI:
ROI = net return on investment / cost of investment x 100
ROI = final value of investment - initial value of investment / cost of investment x 100
Both formulas deliver similar results, but the second formula is for a more exact figure. You can express the final value of the formula as a percentage or ratio.
2. Determine the variables
The next step is to determine the variables. Using the second formula, we can calculate the value of a $350,000 investment into a tech company with a net return of $4,000,000. The investor uses the formula like this:
ROI = 4,000,000 - 350,000 / 350,000 x 100
The next step is to create an ROI estimate based on the percentage value you can generate from the formula. Plug in each variable to determine the final value. Using the formula above, we can calculate an ROI of around 1,043%.
3. Evaluate whether or not to invest
After you calculate the ROI of an asset, you can decide whether it's a good investment that can create returns. Typically, the higher the percentage, the higher the return. In this case, the example produced a 1,043% return on the initial 350,000, which investors might consider an excellent investment choice. Typically, returns of any kind are good, but some investors have particular goals to meet and so only invest in specific assets, industries or companies.
Browse more articles
- 17 Types of Workflow Management Software and Why To Use Them
- What Is MSP in IT Services? Benefits and How To Use it
- How To Set up a Zoom Meeting in Outlook (Plus Benefits)
- What Is Net Income?
- FAQs: Secondary Research (What It Is and When To Use It)
- What Is PaaS? (Definition, Types, Benefits and Drawbacks)
- What Is Operational Risk Management? (Definition and Tips)
- A Definitive Guide to the Toolbar in Excel (With Benefits)
- Snowball Sampling: What It Is and How To Use It in Research
- FAQ: What Is a 1-Year MBA? (Plus Benefits and Pros and Cons)
- What Is Security Testing? (With Types and Related Jobs)
- What Is a Psychology Fellowship? (With Definition and FAQ)