Return on investment (ROI) is a cash flow measure that compares the net return of an investment to the investment’s initial cost. ROI is calculated by the percentage change formula. The formula is shown below:
Where:
- Final Return of Investment = terminal total return
- Initial Cost of Investment = initial total cost
Here, we are simply looking at the difference between what an investment returns and what an investment costs, divided by what the investment costs. This difference in final return and initial cost can be positive or negative, which relates to whether the investment return is positive or negative. ROI can be used to forecast based on proposed cash flows, or ROI can be used retroactively to analyze historical performances. Let’s take a look at an example.
Example
Suppose you as an investor bought 50 shares of stock ABC for $73.00 each at the beginning of the year, and you sold all 50 shares of ABC at the end of the year for $79.00 each. ABC decides to pay out a cash dividend of 5.0% of the market value of the stock per share at the end of the year. The platform you trade on charges a flat fee of $6.99 per trade. What is your ROI?
We can start by determining the final return of the investment. Here, we must consider how much you received by selling the stock, how much you received in dividends, and how much you paid in trading commissions. The total return is calculated below:
Here, I broke the formula down into returns from capital gains, returns from the cash dividend, and how much you had to spend to see that return. At the end of the year, you had a net cash inflow of $4,140.51.
To calculate the initial cost of the investment, we will take a similar approach. The calculation is shown below:
Here, we show the total cost of the investment broken down into what you had to pay to receive the shares of stock plus what you had to pay in trading fees. This is how much you invested at the beginning of the year. You had a cash outflow of $3,656.99.
Now, we just need to plug these values into our formula to calculate our ROI. The final calculation is shown below:
So, your return on investment for the year for your investment in ABC is 13.22%.