What is ROI?
Return on Investment (ROI), is a financial measure of performance that shows how much an investor or a company has gained or lost with an investment.
ROI is an acronym in English for Return On Investiment, which in Portuguese is known as “Return on Investment”.
ROI is used as an investment return indicator, comparing the costs that occurred in the process. ROI relates, for example, to return on sales after an investment in brand advertising.
The formula that calculates this indicator is:
For revenues and costs, those that are directly related to the analyzed investment are considered. In the case of analyzing an investment in a company, for example, it is necessary to consider what were the gains and direct costs to the application.
How to Calculate Return on Investment
Using the ROI calculation formula, the investor finds the percentage of gain his investment had during the period in which he invested his capital.
If this result is, for example, 0.7 it means that the return was 70% compared to the investment costs. If it is a financial investment, the costs can be considered as the capital applied at the beginning of the investment.
In a simplified way, it is possible to measure the return on an investment through a ratio between profit and the value of the acquired asset.
Considering as an example an investment that had a return, after a certain period, R $ 100 thousand, with a total cost of R $ 40 thousand, the calculation is as follows:
ROI = (100,000 – 40,000) / 40,000
ROI = 1.5 or 150%
This means that the investment had a return 1.5 times over its total cost, or a rate of return of 150%.
Meaning of ROI values
The value obtained with the calculation of the ROI indicates the number of times that an asset “leveraged” with its investment, whatever the origin of the invested capital (own or someone else’s).
This application-return relationship depends on what is required by the investor and the characteristics of the market. For example, a 100% return in a very competitive market can be an extremely high return on an investment.
On the other hand, it is necessary to consider other factors that consider the minimum to be required by the company or the investor, such as inflation itself or a possible percentage of reinvestment of the profit obtained.
In a more sophisticated way, it is possible to use the rate that indicates the minimum possible return on investment, known as the Minimum Attractiveness Rate.
The calculation of the expected return, when the investor knows the rate he wants, is done by solving the ROI formula, such as:
In order to know the amount to be invested today to obtain a known return and rate, it is possible to resort to the calculation of the Net Present Value (NPV).
What is ROE?
Return on Equity is a measure of financial performance calculated by dividing net income and equity. It is known in English as return on equity (ROE, see abbreviationfinder.org).
Equity represents a value that corresponds to the assets of a company, which generate income to it, less its liabilities, such as accounts payable, for example.
Net Profit is the measure of all income less the company’s costs. By dividing that amount by equity, it is possible to understand whether a company uses its assets to generate profits efficiently.
How to calculate ROE
To calculate ROE, it is necessary to know the values reached by the company in Net Profit. This measure can be found in the Income Statement or calculated by Total Revenues minus Total Costs, this result being positive.
Shareholders’ equity is a value that can be found as the company’s assets minus liabilities. This amount can be found on the organization’s balance sheet.
For the calculation of ROE, the Average Shareholders’ Equity is used over a period, while there were changes in the assets and liabilities for carrying out the activities. For this, it is possible to add the values in equity at the beginning and end of the year, and divide the result by two.
The formula for calculating ROE is as follows:
This value expresses the Rate of Return on Equity, a percentage that indicates the amount in profits that Equity provided in the period in activity.
How to evaluate the ROE result
A company’s ROE percentage is a value that can be compared with other companies. In this case, it can be useful for anyone interested in investing in the shares of a publicly traded company, for example.
When comparing the profit of two companies, we may not understand very well which one produces more profits with the capital that is invested. To make this comparison, it is possible to calculate the ROE rate.
For example, between two companies with the same Net Profit of R $ 50 thousand in a period, the first with R $ 100 thousand in Equity and the second with R $ 250 thousand. For the period, each had a different ROE:
- Company ROE 1: 50,000.00 ÷ 100,000.00 = 0.5 or 50%
- Company ROE 2: 50,000.00 ÷ 250,000.00 = 0.25 or 25%
For the second company, for every R $ 1.00 invested, the gain is R $ 0.25. This may indicate that, on average, it will take four years for an investor to recover what he has invested. For the first company, this average is half.
This measure is very useful for companies in the same sector, and can make us understand which of the competitors can better take care of the invested capital.
In addition to ROE, other measures can be evaluated to better understand how the company has behaved. Profitability, for example, sees the return of net profit to the amount invested, while profitability measures net profit on the company’s revenues.