ROI stands for Return on Investment and it tells you how much money you've made (or lost) on an investment.

It is a performance measure used to evaluate the efficiency or profitability of an investment. 

ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost.

• Return on Investment (ROI) is a profitability metric used to evaluate how well an investment has performed.

• ROI is expressed as a percentage and is calculated by dividing an investment's net profit (or loss) by its initial cost or outlay.

• ROI can be used to make apples-to-apples comparisons and rank investments in different projects or assets.

• ROI does not take into account the holding period or passage of time, and so it can miss opportunity costs of investing elsewhere.

• investors who are more risk-averse will likely accept lower ROIs in exchange for taking less risk. Likewise, investments that take longer to pay off will generally require a higher ROI in order to be attractive to investors.

What Industries Have the Highest ROI?

• Historically, the average ROI for the S&P 500 has been about 10% per year.

A rate of return (RoR) is the net gain or loss of an investment over a specified period, expressed as a percentage of the investment’s initial cost. 

- determining the percentage change from the beginning of the period until the end.

• The rate of return (RoR) is used to measure the profit or loss of an investment over time.

• The metric of RoR can be used on a variety of assets, from stocks to bonds, real estate, and art.

• The effects of inflation are not taken into consideration in the simple rate of return calculation but are in the real rate of return calculation.

• The internal rate of return (IRR) takes into consideration the time value of money.

Drawbacks of RoR

• The rate of return disregards some key factors in an investment, like the time value of money, the timing and size of cash flows, and the risk and uncertainty associated with any investment.

What Is Considered a Good Return on an Investment?

• A good return on investment is about 7% per year, which is also the average annual return of the S&P 500, adjusting for inflation.

• The required rate of return is the minimum return an investor will accept for owning a company's stock, to compensate them for a given level of risk.

• To accurately calculate the RRR and improve its utility, the investor must also consider his or her cost of capital, the return available from other competing investments, and inflation.

• The RRR is a subjective minimum rate of return; this means that a retiree will have a lower risk tolerance and therefore accept a smaller return than an investor who recently graduated college and may have a higher appetite for risk.

• RRR is in part calculated by adding the risk premium to the expected risk-free rate of return to account for the added volatility and subsequent risk.

Calculating RRR Using the Dividend Discount Model

RRR =  (Expected dividend payment / Share Price) + Forecasted dividend growth rate      

To calculate RRR using the dividend discount model:

• Take the expected dividend payment and divide it by the current stock price.

• Add the result to the forecasted dividend growth rate.

Example of RRR Using the Dividend Discount Model (DDM)

A company is expected to pay an annual dividend of $3 next year, and its stock is currently trading at $100 a share. 

The company has been steadily raising its dividend each year at a 4% growth rate.

RRR = 7% or (($3 expected dividend / $100 per share) + 4% growth rate)

Calculating RRR Using the Capital Asset Pricing Model (CAPM)

RRR =  Risk-free rate of return + Beta X (Market rate of return - Risk-free rate of return)      

To calculate RRR using the CAPM:

• Subtract the risk-free rate of return from the market rate of return.

• Multiply the above figure by the beta of the security.

• Add this result to the risk-free rate to determine the required rate of return.

Example of RRR Using the Capital Asset Pricing Model (CAPM)

Let's say Company A has a beta of 1.50, meaning that it is riskier than the overall market (which has a beta of 1).

To invest in Company A, RRR = 14% or (2% + 1.50 X (10% - 2%))

Company B has a beta of 0.50, which implies that it is less risky than the overall market.

To invest in Company B, RRR = 6% or (2% + 0.50 X (10% - 2%))

Thus, an investor evaluating the merits of investing in Company A versus Company B would require a significantly higher rate of return from Company A because of its much higher beta.

Where RRR is useful?

For capital projects, RRR is useful in determining whether to pursue one project versus another. The RRR is what's needed to go ahead with the project although some projects might not meet the RRR but are in the long-term best interests of the company.

The Gordon growth model (GGM) is a formula used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate.

• The Gordon growth model (GGM) is a formula used to establish the intrinsic value of company stock.

• It assumes that a company exists forever and that there is a constant growth in dividends when valuing a company's stock.

• The GGM works by taking an infinite series of dividends per share and discounting them back to the present using the required rate of return.

• It is a variant of the dividend discount model (DDM).

• The GGM is ideal for companies with steady growth rates, given its assumption of constant dividend growth.

Pros of the Gordon Growth Model

• The GGM is commonly used to establish intrinsic value and is considered the easiest formula to understand.

• The model establishes the value of a company's stock without accounting for market conditions, which simplifies the calculation.

• This straightforward approach also provides a way to compare companies of different sizes and in different industries.

Cons of the Gordon Growth Model

• The Gordon growth model ignores non-dividend factors (such as brand loyalty, customer retention, and intangible assets) that can add to a company's value.

• It assumes that a company's dividend growth rate is stable.

• It can only be used to value stocks that issue dividends, which excludes, for example, most growth stocks.

Equity risk premium refers to an excess return that investing in the stock market provides over a risk-free rate. 

This excess return compensates investors for taking on the relatively higher risk of equity investing. 

The size of the premium varies and depends on the level of risk in a particular portfolio. 

• An equity risk premium is an excess return earned by an investor when they invest in the stock market over a risk-free rate.

• This return compensates investors for taking on the higher risk of equity investing.

• Determining an equity risk premium is theoretical because there's no way to tell how well equities or the equity market will perform in the future.

• Calculating an equity risk premium requires using historical rates of return.

Cost of capital is a calculation of the minimum return that would be necessary in order to justify undertaking a capital budgeting project. It is an evaluation of whether a projected decision can be justified by its cost.

• Cost of capital represents the return a company needs to achieve in order to justify the cost of a capital project, such as purchasing new equipment or constructing a new building.

• Cost of capital encompasses the cost of both equity and debt, weighted according to the company's preferred or existing capital structure. This is known as the weighted average cost of capital (WACC).

• A company's investment decisions for new projects should always generate a return that exceeds the firm's cost of the capital used to finance the project. Otherwise, the project will not generate a return for investors.