A calculation used to determine the expected return of a project in comparison to the cost of the investment. This is normally expressed as a percentage, typically either APR or APY.
This can be done before investing to determine if it is a worthwhile venture to get involved with.
ROI = [ Income - cost/cost ] * 100
It is a concept that is applicable to both fixed income instruments as well as those of the speculative nature. It can also apply to real estate investments.
Business
Return on investment is an important metric for businesses. Here is where C-level executives look at the return on the allocation of resources.
When new divisions, markets, or operations are opened, there is an investment being made. This could be in the form of cash or through debt. Either way, the money is being invested to generate a return on for the organization.
This is a way to determine the profit or loss regarding a particular aspect of the business (or as a whole).
Investors
Return on investment is a metric that investors are very concerned about. This could be based upon an individual portfolio, a hedge fund, or an index fund. Whatever the mechanisms, investors are always seeking a return on their money.
The annual return is often compared to determine which is a better option. Fund managers are often rated based upon the returns they generate. When it comes to a hedge fund, compensation is partially based upon the return over the course of the year.
A negative return on investment is obviously a money losing proposition.
Pros and Cons
The benefit to ROI is the simplicity. It is an easy metric to determine and does provide a powerful snapshot of out resources are performing. This metric can be adjusted to account for different time periods.
A drawback to ROI is on long-term investments. It does not account for the time value of money. This means there is no net present value based upon the basic formula. If one wants to get a true sense of what the return is, over time, this should be factored in.
Another factors is when real property is involved. For example, if a second mortgage is placed on a piece of real estate, this could incur fees and other transaction costs that affect the ROI. Here we would have a layered return, especially if the second was utilized for other purposes.