Return on Investment (ROI)
Published: FinanceTo understand the value of an investment, it's essential to calculate the return on investment (ROI). This article will guide you through the process of calculating the return on investment, which is a crucial step in making informed investment decisions.
Understanding the Concept of Return on Investment
Definition of Return on Investment (ROI)
The Return on Investment (ROI) is the rate of return an investor expects from an investment. It's a crucial metric that helps investors determine whether an investment is worth pursuing.
Parts of the Valuation of an Investment Based on Desired Return on Investment
Operating Income
Operating income is the income generated by an investment before deducting interest and taxes. It represents the cash flow generated by the investment. For instance, a rental property's operating income would include the rent, parking fees, and other income gained directly from the operation of the property.
Operating Expenses
Operating expenses are the costs associated with running the investment. These can include maintenance costs, insurance, and other recurring expenses.
Net Operating Income (NOI)
Net operating income is the income from an investment minus the operating expenses. It represents the cash flow generated by the investment, not including the cost of financing and taxes.
Capitalization Rate (aka "Cap Rate")
The capitalization rate is the rate at which an investment is valued. It's calculated by dividing the net operating income by the value of the investment.
Example Calculation of Return on Investment
The Return on Investment can be calculated as follows:
Return on Investment =
(Net Operating Income / Value of Investment) x 100
Return on Investment =
($100,000 - $20,000) / $1,000,000 x 100
Return on Investment =
8%
In this example, the Return on Investment is 8%. This means that the investor should expect to earn at least 8% on their investment in the rental property.