Return on investment is nothing but the rate at which the investment on a portfolio yields back. Return on investments is used widely by the managers to make investment decision. It is an effective tool in analyzing the investment options. It can also be termed as an instrument to measure the performance of an asset. It is used mainly to compare two or more portfolios. If return on investment is greater than zero then the return is more than the investment and If return on investment is lesser than zero then the return in lesser than investment. The formula used to calculate return on investment is,
ROI = (Gain from investment – Cost of investment)/ Cost of investment.
Gain from investment is got by subtracting the cost of investment from the sales return.
The managers make decision based on the above calculation. Investment will be made if the ROI is greater than zero; else will search for other investment options.
The major drawback in the return on investment method of identifying the best investment option is that it does not include time value in it. Time is a major factor in investments. In the above case the return on investment for an asset which has same cost and same return but different time period will have an equal return on investment value, but in real business scenario the asset with lesser time frame will be selected.
Return on investment along with time value of money is the modern technique that is being adopted by the managers which gives importance to time while calculating ROI. In this technique the major assumption that is being made is that the return from the asset is uniform, i.e. it yields the same return every year. Return on investment along with time value of money is calculated by following two methods which are Rule 72, Rule 114. According to rule 72 the ROI is determined by dividing 72 by the number of years it takes to yield twice the investment from the asset. Similarly using the rule 114 ROI can be determined by dividing 114 by the number of years taken to yield thrice the investment amount.
Even though return on investment seems to be the best option in selecting the portfolio it too has some drawbacks.