Return on investment (ROI): How to measure the key indicator of your investments' success

Whether or not you know your way around the world of investing, you surely know that investing is wise these days for various reasons. But before you dive into it, it's good to have at least a basic overview – and that includes knowing what some of the basic investment terms mean. Today we'll break down return on investment (ROI). What is it, how do you calculate it, and what value does it have for you in practice? Are there other investment indicators? And which one do we use at InvestBay? Find out in the article.

What is ROI (return on investment)?

ROI (Return on Investment) is an indicator of an investment's performance, with which you can evaluate its efficiency or profitability, or compare the efficiency of several different investments. How? It uses the ratio of the cost of the investment vs. the return (or earnings).

What affects ROI?

The key factors affecting ROI include:

• the initial amount of the investment,
• ongoing maintenance costs, and
• the cash flow generated by the investment.

The formula for calculating ROI

You divide the investment's net profit (or, in the worse case, the loss) by its original cost and then multiply this number by 100. You get a percentage. The higher it is, the more profitable the investment.

Let's illustrate this with an example, that is, a concrete calculation of return on investment for an ordinary purchase of an investment property.

Example: Investing in real estate

1. Initial investment:

• Purchase price of the property: 2,500,000 Kč
• Renovation costs: 200,000 Kč
• Legal and administrative fees: 50,000 Kč
• Total initial costs: 2,750,000 Kč

2. Income from the investment:

• Annual rent: 150,000 Kč
• Expected annual growth in the property's value: 3% (75,000 Kč per year)
• Total annual return: 150,000 Kč + 75,000 Kč = 225,000 Kč

3. Operating costs:

• Annual maintenance and management: 20,000 Kč
• Insurance: 10,000 Kč
• Taxes: 5,000 Kč
• Total annual operating costs: 35,000 Kč

4. Net annual income from the investment:

• 225,000 Kč (total annual income) - 35,000 Kč (operating costs) = 190,000 Kč

5. ROI calculation

• ROI = (Net annual income / Initial investment) * 100
• ROI = (190,000 Kč / 2,750,000 Kč) * 100
• ROI = 6.91 %

Result:

The return on investment (ROI) is 6.91% per year. This calculation includes both rental income and the expected growth in the property's value.

In our experience, with ROI people often make the mistake (especially when calculating ROI for real estate) of confusing a 60% return with a 40% loss. An ROI of 60% means that you've earned 60% on top of your original investment.

The significance of ROI for investors

ROI is a popular metric thanks to its universality and simplicity. Essentially, you can use it as a basic measure of the profitability of any investment, and fairly quickly at that.

Even so, ROI is just one of many investment indicators used to evaluate the performance of investments.

Payback period of an investment

The second most common is the so-called Payback Period, or the payback period of an investment. It measures how long it takes for an investment to pay for itself out of the cash flows obtained. It does not, however, take into account returns after payback or the time value of money.

Payback period of an investment: The formula

Assuming the annual cash flows are the same:

Payback period = initial investment / annual cash flow

where the result (the payback of the investment) is in years.

The calculation of the payback period of an investment then looks as follows:

If you invest 10,000 Kč and expect an annual cash flow of 2,000 Kč, the payback period is 10,000 Kč / 2,000 Kč per year = 5 years.

Comparing ROI with other investment indicators

Below is a comparison of ROI with other significant investment indicators. Among them you'll also find an explanation of the one that we use at InvestBay for calculating the estimated return – IRR.

1. ROE (Return on Equity): Measures the return on equity, i.e. how much profit a company generates for every crown of equity.
   While ROI evaluates the overall performance of an investment regardless of the source of financing, ROE focuses only on the profitability of equity. ROE is useful for shareholders who want to know how efficiently their invested capital is being used.
   
2. ROA (Return on Assets): Measures how efficiently a company uses its total assets to generate profit.
   While ROI measures the return on the total investment, ROA focuses on the efficiency of the use of a company's assets. ROA is useful for assessing how well a company uses its resources to create profit.
   
3. IRR (Internal Rate of Return): This is the discount rate at which the net present value (NPV) of all cash flows (income and expenses) from an investment equals zero. We use this indicator at InvestBay to calculate and estimate future returns. In other words: what we state in the section as the estimated return is the IRR.
   IRR takes into account the time value of money and provides a compound annual rate of return. Unlike simple ROI, which does not take time into account, IRR provides a deeper view of an investment's potential returns over time.
   
4. NPV (Net Present Value): Represents the difference between the present value of the cash flows received from an investment and the present value of the cash flows spent on the investment.
   NPV provides an absolute measurement of profitability and takes into account the time value of money. ROI is a percentage indicator and is simpler to calculate, but it may not provide as comprehensive a view of an investment as NPV.

Each of these indicators has its specific use and provides different perspectives on an investment's performance. Investors often use a combination of these indicators to get a comprehensive overview of an investment's potential and risks.

What is a good return on a real-estate investment?

There is no universal benchmark that would tell you off the bat what a good return on an investment is. That's because several factors affect it.

• Risk tolerance: Investors differ in their willingness to tolerate risk. Those who are more risk-averse may accept a lower return on investment in exchange for greater stability and predictability of their investments. On the other hand, risk-tolerant investors may strive for a higher return on investment, but are willing to accept greater uncertainty and volatility.
  
• Duration of the investment: The investment's time horizon plays a significant role in determining what can be considered a good return on investment. Longer-term investments usually require a higher ROI to justify tying up capital for a longer period. Short-term investments may offer a lower return on investment, but provide liquidity and flexibility.
  
• Industry norms: Different industries have different expectations regarding return on investment based on factors such as market conditions, the competitive environment, and the regulatory environment. For example, industries with high barriers to entry or substantial capital requirements may require a higher return on investment in order to attract investment.
  
• Personal goals: Ultimately, what is considered a "good" return on investment depends on the investor's specific financial goals. Whether investors are striving for wealth accumulation, income generation, or capital preservation, they should adjust their return-on-investment expectations to their individual goals and circumstances.

Return on investment at InvestBay

The return on a real-estate investment at InvestBay is slightly different – it isn't linear over time. It has two components:

• rent
• total appreciation in price

For each of the investment properties we offer, you see exactly the expected annual appreciation of the property as well as the expected annual return from rent in relation to the property's value. The calculated values are based on our thorough analysis.

You receive rent on an ongoing basis, but these are rather small amounts. To be honest, with none of our current properties is it the dominant component.

The total appreciation in price (or capital growth) then makes up most of your return and is realized at the end upon sale.

Read more on our How it works page.

How do we at InvestBay select properties?

For that we have the most qualified people on the team – our real-estate expert Andrew Thompson has been active in the real-estate market for over 27 years. What do we insist on when selecting properties?

• We stick to several proven criteria that stem from our many years of experience in this field.
• We only choose projects/properties that already stand and for which we have enough data to assess their profitability.
• Even though we look for projects with the greatest possible return, when we sense high risk from a project, we give preference to another. We simply do everything we can to make your money earn.

Give it a try. We're as transparent as we can be, so you know what you're getting into. Sign up today and take a look at the current investment offering. You can start with 2,500 Kč, but you'll surely soon understand the advantages of investing with InvestBay firsthand and invest more.