Are you interested into trying your hand to some small-scale investments of your personal finances? That’s a wonderful way to expand your portfolio and personal expanses. Even higher education facilities such as the Harvey Mudd college offer ROI for their students and investors. First of all, you should know that’s a very good idea, since your personal earnings can only get you so far. Second of all, the world of investments may seem a little intimidating at first if you’re a beginner, but we will walk you through the basics of what you need to know. Today’s post will give you all the required details about the return on investment (ROI), the ROI formula and all you need to know about using a ROI calculator.
What is the Return on Investment Rate?
The rate of return on investment, usually shortened to simply ROI, is the number one indicator you need whenever you are checking out a potential investment. Any investor, whether he or she is an amateur or a professional, needs the ROI in order to be able to properly evaluate an investment opportunity and make a decision about it. The return on investment lets you know exactly how much money you get back for each amount you initially put into that investment; so it’s basically the only way to assess how profitable a venture is and whether it is worth it or not.
The official definition of the return on investment is this: the ROI is the benefit to an investor, resulting from the investment of some resource (usually money). The higher the ROI is, the more profitable the investment is, since it compares favorably to the cost of the investment. Therefore, you want your ROI formula to result in rates higher rather than lower, whenever evaluating a potential investment.
Speaking of the ROI formula, here it is: the return of investment can be deduced by calculating the (Gains – Cost) / Cost.
This means that you need to calculate the profit you will be obtaining (Gains – Cost) and then divide it by the cost of the initial investment (Cost). The result tells you how profitable the investment can be and whether it’s worth it. Let’s take a look at an example so you can understand the concept of ROI better.
Example: Let’s say that you are being asked by a friend to invest into his brand new idea for a business. He asks you to buy some shares, and each of them costs $5. You decide to buy 40 shares, meaning that you have to invest a total of $200 into your friend’s business. The friend then vouches to buy back those shares from you after a few months, for $6 a share. This means that you will get back $240, and in this case, the ROI will be (240-200)/200, which equals 0.2. That is your return on investment rate: 0.2 or 20%. It means that you will get back whatever you invest, plus 20% of your initial investment.
The more money you invest into the opportunity you’ve found, the larger will the gains be. But the ROI of an investment opportunity will stay the same, no matter how much more money you put into it. If you find a promising investment, feel free to go for it, but also discuss the terms in detail with your deal provider; you should take other factors into account besides the ROI (like the level of risk, the total time you need to wait before claiming your investment’s returns and so on).
How to Formulate and Use Your ROI Calculator
The basic tool you will need whenever considering an investment is the ROI calculator. There are several examples and fancy tools to be found online for calculating the ROI, some of them are free and some require payment, but none are as trustworthy as formulating your own ROI calculator. The basic style of calculating the ROI if you’re a beginner just starting their journey in the world of small-scale investments is simply by following the basic formula presented above.
Just pick out a small sum for your initial investment (within the limit of a few hundred dollars, the way we did in our example). Then calculate the ROI with the help of that fictional sum to be invested (as we mentioned above, don’t worry, the ROI obtained would be the same for larger sums as well). After you obtain your figure, compare it to how much would the ROI be if you simply invested your money to the bank (the interest rates for deposits) and see if it’s worth it.
Calculating the CAGR Formula
You should also learn more about the Compound Annual Growth Rate (CAGR) if you want to get better at making investments. This is similar to a return on investment calculation, only that it also takes the time into account. The CAGR signifies the geometric progression ratio (growth rate) of the constant returns you get from an investment over a limited time period. If you invest your money for a whole year into a business and get monthly returns that still remain invested there for a larger pay-off at the end of the investment time, you can find out just how profitable this is by calculating the CAGR.
The CAGR formula is pretty simple and intuitive:
As you can see, first you need to divide the value of an investment at the end of its time by the value of the same investment at the beginning. Then, you need to raise the result to the power of one divided by the length of time planned out for the investment, and then, finally, subtract 1 from the end result. Follow this CAGR formula and the result you will obtain is basically the median annual growth rate for the investment you are evaluating. Just like in the case of the ROI, you will want this value to be as high as possible. Now that you know how to work with both the CAGR formula and the ROI formula, you are prepared to make your first investment decisions. Good luck!
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