Return on investment is the ratio between the net profit and cost of investment resulting from an investment of some resource. A high ROI means the investment's gains compare favorably to its cost. As a performance measure, ROI is used to evaluate the efficiency of an investment or to compare the efficiencies of several different investments. In purely economic terms, it is one way of relating profits to capital invested.
It is a performance measure used to evaluate proficiency of an investment or compare the competence of different investments. It measures the amount of return on an investment associated with the investment cost.
"Gain from Investment" in the above formula refers to profits that are obtained from sale of investment of interest. As ROI is measured as a percentage it can be compared with returns from other investments thereby allowing one to measure various types of investments against one another.
ROI is a well-known metric due to its flexibility and effortlessness. Return on investment can be calculated and interpreted easily besides being applied to wide range of investments. In case the investment does not have positive ROI and other opportunities available with higher ROI, then ROI values could initiate the person to an investment that are preferable to other.
ROI inherently accounts for an amount of time during which investment in question takes place. This metric is often used in conjunction with rate of return that essentially pertains to specified period of time unlike ROI. One can also incorporate Net Present Value that accounts for differences in the value of money over time due to inflation or sometimes due to precise ROI calculations. The application of Net Present Value while calculating rate of return is often called as the Real Rate of Return.
It is important that you keep in mind the meaning of calculating a return on investment and its definition which can be altered to suit the situation. Everything depends on what one includes as costs and returns. The definition of the term in simple words attempts to measure the profitability of investment and there is no one standard calculation.
While using ROI to assess investments in real estate, one uses initial purchase price of the property as the cost of investment and the ultimate sale price as the gain from investment, though it fails to account for all the intermediary costs like property tax, renovation and real estate agent fees. This flexibility puts forth another limitation of using ROI. These ROI calculations are easy to manipulate to suit the user’s purpose and the results can be expressed in different ways. While using the metric, the investor makes sure that he understands the inputs being used. Just the return on investment ratio cannot paint a picture that looks quite different from what one may call an accurate ROI calculation. Incorporation of relevant expenses goes into the maintenance and development of an investment over a period of time.
Many investors and businesses today have taken keen interest in the development of new forms of ROI metric known as "Social Return on Investment". This was initially developed in the early 00s and takes into account social impacts of projects and works towards including those affected by the decisions in planning the allocation of capital and other resources.