What Is Return on Investment (ROI)?
Return on investment (ROI) is a measuring tool investors use to see how well their investment in a particular company is faring — and to help them make that important decision to sell a stock and move on or to stick with it. Potential investors also use ROI when trying to make a decision among different companies in which to plunk their spare cash.
Investors want to see how well company management is using the company assets to make money. This information gives the investor some idea of the competency of management and the relative profitability of a business when compared to others the investor is considering.
Investors can calculate ROI, which is expressed as a percentage, a few different ways. All the methods involve using some form of comparing income to assets. Here are two common methods:
Net income divided by average total assets: Net income (see Book VIII, Chapter 1) is the bottom-line total of what’s left over after you deduct all business expenses and losses from all revenue and gains for the same financial period. Assets are all the resources a company owns. So if a company has net income of $100,000 and average total assets of $2,700,000, its ROI is 3.7 percent ($100,000 / $2,700,000).
To determine the average of any account, add the account balance at the beginning of the financial period to the ending balance and divide that figure by two. So, if total liabilities are $50,000 on January 1 and $75,000 on December 31, average total liabilities is $125,000 / 2 = $62,500.
Operating income divided by average operating assets: This form of ROI calculation starts with income before income taxes and interest and divides it by average operating assets, which are long-lived assets such as property, plant, and equipment. So if a company’s operating income is $82,000 and its average operating assets are $1,200,000, ROI using this method is 6.83 percent ($82,000 / $1,200,000).
In real life, it doesn’t make any difference which method an investor uses. As long as the chosen method is used consistently, trend analysis using any ROI method will give the investor a significant resource for making a decision as to which company to invest in.