What is return on investment (ROI)? How to understand, measure, and use it

ROI is a common financial metric used to evaluate how profitable a specific investment or savings account might be. Learn how to understand, calculate, and use ROI when making more informed financial decisions. 

The acronym ROI stands for Return on Investment. It’s a metric that measures the financial gain or loss of an investment relative to its initial cost.

ROI is expressed as a percentage, which allows you to compare different savings and investment choices side-by-side. By knowing your potential return and how it relates to your initial investment, you can make more informed decisions about where to put your money. Calculating ROI also helps you manage your existing portfolio by understanding how your investments are performing. 

To calculate ROI, first take the total current value of your investment and subtract the initial amount you put in. This gives you your net profit. Then, divide that net profit figure by the initial cost. Finally, you multiply the result by 100 to convert it into a percentage.

The concept of return on investment applies to almost every area where money is spent with the goal of making a profit. However, the way you look at it can change depending on whether you are managing a company budget or growing your personal wealth.

In the business world, ROI is used to measure the success of specific projects or expenditures. A company might calculate the return on a new marketing campaign by comparing the revenue it generated against the cost of the adverts.

Business owners also look at the ROI of buying new equipment, investing in employee training, and other similar initiatives. They will look to prioritise initiatives that deliver good ROI, which helps to show that they make good business sense. If new machinery speeds up production and increases sales, for example, the positive ROI justifies the initial cost.

ROI can also be used to measure the growth of savings or investments in personal finance. This could mean anything from calculating the profit from selling an investment property, to tracking the performance of stocks and shares in your ISA.

When looking at a basic one-year fixed rate bond in the UK, your absolute ROI for that year will typically match the Annual Equivalent Rate (AER).  The AER shows you what your return on investment will be over a year, making it easy to compare different savings products. 

For example, imagine you place £10,000.00 into a 1 Year Fixed Rate Bond offering an illustrative rate of 5.00% AER. The rate is fixed, so you can calculate your interest by multiplying the initial investment by the interest rate, or 0.05, to reach a total of £500.00. Once you know this, you can calculate the ROI:

• Step 1 (Find the net profit): £10,500.00 - £10,000.00 = £500.00.
• Step 2 (Divide by initial cost): £500.00/£10,000.00 = 0.05.
• Step 3 (Convert to percentage): 0.05 x 100 = 5 %.

In this scenario, you can see how the ROI for that year matches the AER of 5%. Please note: this example is for illustrative purposes only.

While ROI is a helpful starting point, it does have a few limitations when tracking investments or deciding how and where to invest. Primarily, the standard calculation does not account for the length of time you hold an investment. A 10% return over one year is vastly different from a 10% return over five years. The basic formula also does not factor in the level of risk involved or hidden costs like platform fees and taxes.

To build a clearer picture, ROI can also be used alongside other metrics to get a deeper understanding of performance, particularly over longer periods of time. Other helpful metrics might include rate of return (RoR), which accounts for the exact timeframe of your investment to give you an annualiszed growth rate. You might also use Net Present Value (NPV), which accounts for the time value of money. NPV helps you understand how factors like inflation and potential interest affect what your future returns are actually worth in today's terms. Additionally, the payback period is a helpful calculation that shows exactly how long it will take to recover your initial investment cost.

For personal savings, it is also important to remember that the basic ROI formula misses the accelerating effect of compound interest. ROI only measures the total profit against the initial cost, so it does not capture how earning interest on top of your previous interest speeds up your growth. 

While some investments like stocks can offer higher returns, they also come with a level of risk where you could get back less than you put in. If you are looking for a predictable and reliable return on investment, savings accounts may be able to offer you what you need. 

Through the Raisin UK marketplace, you can access competitive interest rates offered by our partner banks. When you open an account, the interest rate is clearly displayed. Depending on the type of account, this may change during the term, but unlike an investment, you don’t risk market fluctuations that could undo good ROI and lead you to lose money. Your eligible deposits will be protected up to £120,000 per institution and per depositor by the Financial Services Compensation Scheme (FSCS).