What is return on investment?

Return on investment is a basic concept that forms the starting point for any discussion of the efficiency of capital investment. Put simply, it shows whether an investment has generated a profit and how it compares to the resources used.

ROI allows you to compare different opportunities, filter out emotions, and focus on facts. This is why it is an essential skill for anyone who wants to invest consciously rather than intuitively.

Key indicators used to determine ROI

ROI — the classic indicator of return on investment

ROI is the most commonly used indicator for assessing return on investment, due to its simplicity and versatility. When evaluating the effectiveness of investments or determining whether an investment has produced financial results, both novice and experienced investors begin with ROI.

The classic ROI formula looks like this:

ROI = (net profit / total investment) × 100%

Or, in expanded form:

ROI = (return on investment – total investment) / total investment × 100%

ROI is useful in several cases.

• Fixation of the results after exit.
• Comparing various transactions with the same time horizon.
• It can also be used for a preliminary assessment of investment effectiveness when a quick decision is required.

However, ROI has limitations. It does not consider time, risk level or liquidity. An ROI of 60% in one year and the same indicator over six years represent fundamentally different investments. This is why, in venture investments, ROI is used as a starting point for analysis rather than the only criterion.

Savvy investors always combine this formula with an understanding of the context, alternatives, and portfolio logic. Only then does ROI become a useful tool rather than a misleading figure.

When should ROE, ROMI and IRR be used?

When ROI is no longer sufficient, more specialised metrics such as ROE, ROMI and IRR come into play. Each one answers different investment questions and is used in a specific context.

ROE (return on equity) shows the return on a company's equity capital. This indicator is particularly important for investors entering a business at a stage where financial statements have already been established. ROE enables you to evaluate the effectiveness with which management utilises shareholders' funds.

ROMI (Return on Marketing Investment) focuses exclusively on the effectiveness of marketing expenditure. It is particularly interesting for startups in the scaling phase, as it answers whether marketing investment translates into real revenue growth.

IRR (Internal Rate of Return) is one of the key indicators used in professional investment. It accounts for the time value of money and shows the average annual return on investment, considering all cash flows. It is the IRR that enables you to compare projects with different implementation periods accurately.

The key difference between these indicators is their purpose: ROI focuses on the overall result, ROE centres on capital efficiency, ROMI emphasises growth through marketing, and IRR hinges on profitability over time. Competent investors do not choose one indicator, but combine them to gain a comprehensive understanding of the actual return on investment.

How to correctly calculate return on investment: a step-by-step guide

Step 1: Determine the amount of investment

This is the first and often underestimated step in calculating ROI. Many investors mistakenly limit themselves to the initial cheque, ignoring the real cost of entering the project.

The investment amount should include all direct expenses, such as invested capital, additional rounds of financing, convertible instruments and participation in follow-on investments. However, the list does not end there.

It is important to consider hidden costs that do not always appear in financial reports. These may include legal services, due diligence costs, tax structuring and platform or fund commissions.

Additional expenses associated with participating in the project require special attention. The time spent on mentoring, strategic sessions and searching for partners or clients must also be factored in. In the VC environment, this is frequently referred to as 'invisible capital', but it is precisely these costs that affect the real return on investment.

Experienced investors understand that incorrectly estimating the investment amount can artificially inflate profitability indicators and create an illusion of success. A clear and honest definition of all expenses is essential for further calculations. Without this, any formula loses its meaning and investment decisions become risky, even in promising projects.

Step 2 — determine net profit

The second step in calculating profitability is determining net profit. Confusion is most common at this stage, particularly among those who are just starting to invest. The main mistake is to equate profit with turnover or gross income, which is fundamentally the wrong approach.

Net profit is the result that remains after deducting all expenses, taxes, and liabilities. In venture capital investments, it is usually fixed at the moment of exit. Profitability is calculated by subtracting the amount received at the exit from the total amount invested.

It is important to consider real rather than nominal indicators. An increase in a startup's valuation on paper does not necessarily mean a profit for the investor. Until the moment of liquidity, any figures remain potential. That is why professional venture investors always separate ‘paper success’ from actual financial results.

Tax implications, commissions, and possible restrictions on the withdrawal of funds should also be considered. In international transactions, they can significantly affect the final result. Net profit is not an optimistic scenario, but a conservative estimate of what the investor actually gets.

Step 3: Apply the formula

Once you have determined the total investment amount and net profit, you can apply the profitability formula. The most basic tool for this is ROI, which allows you to quickly assess the effectiveness of an investment. The formula is as follows: net profit divided by investment amount, multiplied by 100%.

Let's look at a simple example. If the total investment was $200,000 and the output was $350,000, the net profit would be $150,000. In this case, the ROI is 75%. This means that the investment yielded a 75% return on the capital invested.

However, when it comes to venture capital investments, it is important not to stop at the number itself. The resulting figure must be interpreted. For example, an ROI of 75% could be an excellent finish over two years and a mediocre result over eight.

Investors should use the profitability calculation as a starting point for further analysis, comparing the result with alternative opportunities, risk levels and portfolio structure. While the formula provides clarity, it is the context that determines whether the investment was truly profitable.

In addition to the standard ROI formula, a simplified model is often used in investment practice to quickly assess the effectiveness of an investment without detailing the income structure.

ROI = (Financial result / Investment amount) × 100%

In this case, the financial result is the difference between all funds received and all investment-related expenses.

Let's look at an example. You invested $180,000 in a project. During the investment period, you received a total income of $255,000, including all payments and the final exit. The financial result is:

$255,000 – $180,000 = $75,000

We can then substitute this data into the formula:

Profitability = (75,000/180,000)×100%≈41.7%

This indicates that the investment yielded a 41.7% return on capital invested. In a VC world, however, it is imperative not to stop at the number itself. The period over which this result was achieved must be assessed, as must the level of risk associated with the investment.

This is why the profitability formula is useful for initial estimates. It enables you to quickly determine whether a detailed analysis is warranted or if a better alternative should be sought. For a venture investor, it provides a means of making objective decisions.

Examples of how to calculate the profitability of various investments

Example for a business

Investments in businesses are most similar to venture capital, as they offer high-growth potential alongside an increased level of risk. Consider a hypothetical example of successful earnings from a typical business.

An investor puts $400,000 into setting up a small furniture manufacturing workshop. Over the course of five years, the business operates steadily, pays for itself, and establishes a customer base. The investor then sells the business as an operating asset for $700,000. Now, let's calculate using the formula:

• Invested: $400,000
• Received upon exit: $700,000 (after three to five years of operation)
• Net earnings: $700,000 – $400,000 = $300,000
• ROI calculation: ($300,000 / $400,000) x 100% = 75%

Example: real estate

Although investments in real estate are often perceived as more straightforward, careful calculation is still required to ensure profitability. Consider the following scenario: a property is purchased for $1 million, intending to rent it out. The annual rental income is $100,000, after deducting maintenance costs and taxes.

At first glance, the profitability seems obvious, with an ROI of 10% per annum. However, there are several nuances. Firstly, the payback period must be considered — in this case, around ten years. Secondly, the liquidity of the asset must be assessed, as well as possible downtime, repair costs, and changes in market value.

If the property were to be sold for $1.3 million after five years, the overall picture would change. The price increase would result in rental income and additional profit for the investor. In this case, the ROI increases; however, a time factor also comes into play that needs to be assessed separately.

Formula:

ROI = (net rental income + increase in property value – investment amount) / investment amount × 100%

Example:

• Purchase price: $1,000,000
• Net rental income for the year: $90,000
• Sale price after one year: $1,100,000.

Total income:

$90,000 + ($1,100,000 – $1,000,000) = $190,000

ROI calculation:

($190,000 / $1,000,000) × 100% = 19%

Example of financial investment

Financial instruments, such as bonds, shares and investment funds, have their own profitability logic, which differs from that of business and real estate. For instance, if an investor were to invest $200,000 in a diversified fund, they would earn $30,000 in net income per year. In this case, the ROI is 15%.

The advantages of such investments are their relative predictability and liquidity. Investors can quickly exit a position, lock in a profit or loss, and reinvest the funds.

In the case of shares, however, volatility complicates matters. While profitability may appear high on paper, it cannot be realised without locking in the position. Bonds, on the other hand, provide lower but more stable income. This is why financial investments are often used to preserve capital rather than for aggressive growth.

Formula:

ROI = (dividends + interest + change in asset price) / investment amount × 100%

Example:

• Invested: $200,000
• Dividends for the year: $12,000
• Asset value growth: $18,000

Total income:

$12,000 + $18,000 = $30,000

ROI calculation:

($30,000 ÷ $200,000) × 100% = 15%

How can you tell whether an investment is profitable?

The concept of 'good return' does not have a universal meaning, and this is one of the key truths that investors should understand from the outset. The same figure can represent an excellent result in one context and a mediocre one in another. When it comes to venture capital investments, returns are always assessed relative to risk, time, and alternatives.

For conservative instruments such as bonds or deposits, an annual return of 8-10% may be considered acceptable. A venture fund is rated successful if its DPI (Distributed to Paid-In Capital) is greater than 3x over a 10-year cycle. This corresponds to an IRR of approximately 20-25%. If a venture investor earns less than 15% per annum, they are effectively underperforming compared to the S&P 500 index, given the enormous risk involved.

To determine the profitability of an investment, ask yourself the following questions: What is the real risk of capital loss? How long will the money be unavailable? What are your alternatives today? If the expected return does not exceed that of alternative opportunities when the risk is addressed, such an investment is unlikely to be justified. It is the balance of these factors that determines the outcome, not a single percentage figure.

What are the most common mistakes made when calculating profitability?

One of the most common mistakes is using incomplete data. Investors frequently focus solely on the initial investment amount, ignoring other costs such as legal fees, taxes, commissions, and time and resources spent. As a result, the profitability indicator appears much better than it actually is.

Another common mistake is confusing turnover with profit. An increase in a company's revenue does not necessarily mean that investors have made a profit. Without taking all expenses and actual cash flow into account, any calculation loses its meaning. This is particularly pertinent for startups, which may not generate a net profit for years.

Another critical mistake is ignoring the time factor. ROI without reference to the investment's duration creates a false impression of effectiveness. An investment with a high percentage but a long-time horizon may be inferior to a less profitable but faster alternative.

Risk is also often underestimated. Profitability is calculated based on a guaranteed scenario, even though complete capital loss is always a possibility in venture capital. Professional investors think in terms of probabilities, not optimistic forecasts.

Another common misconception is analysing investments in isolation. Without considering the portfolio and alternatives, any profitability indicator is incomplete. A systematic approach allows you to avoid these mistakes and make informed decisions.

How can you increase your return on investment?

The first step is disciplined analysis. A thorough understanding of the business model, market, competitive advantages, and team will help to reduce the possibility of errors. While investors cannot eliminate risk entirely, they can avoid obviously weak deals.

The second important factor is diversification. A venture portfolio rarely succeeds based on a single investment. It is the distribution of capital across different projects, stages, and sectors that increases the likelihood of achieving a high return.

Your active participation can also have an impact on profitability. Investors who contribute expertise, contacts, or support often improve a startup's chances of success.

An exit strategy is equally relevant. Clearly understanding potential exit scenarios from the outset helps to avoid situations where capital gets stuck with no prospect of liquidity.

Conclusion: How can you quickly assess whether an investment is profitable?

While quickly assessing the profitability of an investment is a skill that comes with experience, the basic principles are accessible to everyone. Firstly, it is essential to separate emotions from numbers. An attractive idea or a charismatic team are no substitute for cold calculation.

The first step is to understand exactly how many resources you are investing. The second step is to determine a realistic profit-making scenario, rather than an optimistic one. Thirdly, you need to assess the time horizon and liquidity. If the money will be unavailable for years, the expected return must compensate for this.

Next, compare the investment with alternatives. If a similar return can be obtained with less risk, additional arguments are required to justify the investment. It is the comparison, rather than the absolute figures, that provides an objective answer.

Finally, evaluate the investment as part of a portfolio rather than as a single bet. Investments work in aggregate, where overall profitability is more important than the outcome of a single transaction. If all these elements come together to form a coherent picture, the investment can be considered profitable.