Return On Investment (ROI)

Return On Investment (ROI) is one of the most common performance metrics. It is used to evaluate the profitability of an individual company and to compare the performance of a number of different investments.

ROI - Return On Investment

Return On Investment (ROI) is one of the most common performance metrics. It is used to evaluate the profitability of an individual company and to compare the performance of a number of different investments.

However, the ROI isn't a stand alone decision-making tool, as the figure only shows how returns compare to costs at present, without consideration for risks or changes in the operating environment.  In addition, the definition of ROI is flexible and the investor should be wary of what figures were used to calculate the metric.

 

Return On Investment Formula

To calculate the ROI, the benefit (or return) of an investment is divided by the investment cost(s); the result is expressed as a percentage.

Return On Investment Formula:  ROI = ( (Gains - Investment Costs) / Investment Costs ) * 100%

As with most company fundamental factors, there are different variations and as mentioned before, no universal standard for its calculation.  Two commonly variations used by analysts are:

  • Trailing ROI:   trailing 12 month Income After Taxes divided by the average Total Long Term Debt and Stockholders Equity, expressed as a percentage. 
  • Quarterly ROI:    the most recent quarterly Income After Taxes divided by the average Total Long Term Debt and Stockholders Equity, expressed as a percentage. 


Return On Investment Interpretation

Return On Investment is one of several commonly used financial metrics for evaluating business investments, management of stock portfolios or the use of venture capital. A high ROI means that investment gains compare favorably to investment costs.

One serious problem with using Return On Investment is that ROI by itself says nothing about whether expected returns and costs will appear as predicted. In other words, ROI says nothing about the risk of an investment. ROI simply shows how returns compare to costs if the action or investment brings the results hoped for.



Related Terms


Quantitative Analysis of Return On Investment

Good quantitative factors exhibit relationships with stock returns that not only have a fundamental and/or theoretical basis for stock returns but are also stable and persistent over time. The Return On Investment has been correlated with past stock returns for decades and also expected to be correlated with future returns. 

Investment Horizon

The ROI exhibits the best quantitative characteristics when analyzed using a short investment horizon.  The investment horizon is referred to as "rebalance period" by Quantitative Analysts.  The rebalance period is the time a stock is held prior to refreshing the portfolio holdings. While the Return On Investment achieves good results with weekly, monthly, quarterly rebalance, the factor performs best with an investment horizon of 1 week using the Quarterly ROI.  

Quintile Back-Test

The Quantitative Analyst assesses individual stock factors by:

  • separating the stocks into quintiles (or deciles) based on the value of the factor
  • calculating the performance of each quintile based on rebalance period and total back-test period
  • analyzing the spread of performance between Quintile 1 to Quintile 5

Ideally the performance spread should be "monotonic", meaning that Quintile 1 outperforms Quintile 2, Quintile 2 outperforms Quintile 3, and so forth.

Test Results

Using the process described above, the stocks from the Russell3000 Index were evaluated over the 10 year backtest period 2005-2014 with a weekly rebalance period, using the Quarterly Return On Investment. 

10 Year back-test performance of the Quarterly Return On Investment (ROI) with weekly rebalance period. Annualized percent profit versus quintile.

10 Year back-test performance of the Quarterly Return On Investment (ROI) with weekly rebalance period. Annualized percent profit versus quintile.

Equity curves for Russell3000 10 year ROI quintiles

Equity curves for Russell3000 10 year ROI quintiles

In Quantitative Analysis,  single factor back-tests are not executed to generate real-life performance figures or to outdo a benchmark. At this stage the Technical Analyst is simply trying to identify whether the stock factor contains useful predictive value. As can be seen from the above column chart, the quintiles exhibit monotonic behavior, meaning that the quarterly ROI provides useful predictive value. There are many other considerations involved in the construction of a portfolio that will change the performance numbers.