What Is Return on Investment (ROI)?
Return on Investment (ROI) shows whether an investment creates value — and by how much.
Return is a fundamental concept in both engineering and finance. In its simplest form, return describes the relationship between what you put in and what you get out. On this page, we focus primarily on the financial meaning of return and Return on Investment (ROI), using clear examples and formulas.
Return in Technology and Finance
The concept of return is widely used in different fields. In the technical world, return often refers to the efficiency of a process, such as the amount of energy produced relative to the amount of energy consumed. In finance, return has a more specific meaning: it represents the profit or loss generated by an investment, expressed relative to the amount invested.
In financial terms, return answers a simple question: how much did an investment grow (or shrink) relative to its initial cost? For example, if you invest 100 units and later receive 120 units, the return is 20%. Returns are almost always expressed over a period of time, such as per year.
Why a Simple Definition of Return Is Not Enough
However, this intuitive definition becomes insufficient when we want to compare different economic activities. Consider two activities, A and B. Activity A generates a yield of $10, while activity B generates a yield of $100. At first glance, activity B seems superior. But is that really true?
Calculating Return: A Cost-Based Example
Problem 1
Suppose producing product A costs $1, while producing product B costs $95. The resulting profits are $9 and $5,
respectively. When costs are taken into account, activity A generates a higher return relative to its investment.
Calculating Return: The Role of Time
Problem 2
The comparison is still incomplete. Suppose product A takes 10 months to produce, while product B takes only
2 months.
Activity A generates $9 over 10 months, or $0.90 per month ($10.80 per year). Activity B generates $5 over 2 months, or $2.50 per month ($30 per year). Once time is taken into account, activity B again produces the higher return.
This example highlights a crucial insight: return is not only about profit and cost, but also about time. Investors therefore compare returns on a time-adjusted basis, typically per year.
A Practical Definition of Return
Based on the examples above, a useful working definition of return is:
Return is the total yield of an economic activity over one year divided by the costs or purchase price of that activity.
Different Definitions of Return
Even this definition is not universal. Different economic activities measure yield in different ways, which is why multiple return metrics exist. These range from simple ratios used in everyday financial decisions to more advanced concepts such as the Internal Rate of Return (IRR).
What matters most is not the specific formula used, but that return is communicated clearly and consistently, especially when comparing investment opportunities.
Common Return Formulas
Dividend yield on stocks (%):
Dividends received in the last 12 months / current stock price
Return on stocks (%):
Reported earnings in the last 12 months / current stock price
Return on bonds (%):
Coupon payments in the last 12 months / bond price
Return on rental property (%):
Rental income in the last 12 months / current property value
Return and Startup Valuation
While return metrics such as ROI are useful for comparing opportunities, they do not by themselves determine the value of a company. Valuation requires estimating future cash flows and adjusting them for risk and time. In later stages, uncertainty in these cash flows can be modeled using techniques such as a Monte Carlo simulation.
In our series on startup valuation, we therefore move beyond simple return measures and continue with the Discounted Cash Flow (DCF) method, which forms the foundation of modern valuation analysis.