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ROI
Return on Investment
ROI or Return on Investment is a common term used by investors to describe the percentage of profits made on any given investment. In this way, two investments can be compared to each other to determine which one will be more profitable. This is the equation used to determine the return on investment.
Profit / Money Invested x 100 = %ROI
Example 1 - 4.02% ROI
Chico opens a savings account with $5,000 at 1% interest quarterly. After one year untouched, the balance in his savings account is $5,201 (and some change). Using the formula above, Chico's ROI for this investment would be 4.02%.
In this situation, Chico's initial investment has not been made back in profits (and it will take some time to do so). The original investment has remained parked in this one "deal", therefore the strategy is slow and has very little velocity. The initial investment came entirely from Chico's own personal savings, therefore the investment has no built in leverage.
Example 2 - 400% ROI
Charley buys and restores classic cars for hobby and profit. It takes a bit more knowledge and experience than just saving his money, but he enjoys the work and nobody does it better. With a smart $5,000 investment in the right car and materials, he can turn an oldie into a beauty that would easily sell for $10,000.
It takes Charley about two months to do his work, and perhaps another month to sell the finished car. So, in an average year Charley will move his initial $5,000 investment into (and back out of) four cars. Each time he sells a car he gets back his initial investment and also returns 100% on his investment as profit. Using the formula above, Charley's ROI for the year is 400%. The initial investment of $5,000 has moved from one investment to another through four different deals, therefore his investment strategy does have a little velocity to it.
Charley uses all of his own money, does all of the work himself, and he has no set business systems in place. Therefore, as in Example 1, his strategy uses very little leverage.
Example 3 - Infinite % ROI
Keith finds an owner selling a small, 6 lot trailer park in a nice rural location. The trailers are roomy and in excellent condition. Five of the trailers are occupied, two of them with long term tenants. Lot fees are $100 a month. Trailer fees are $250 a month.
The owner wants $50,000 for the whole deal. Keith knows with his good credit and a solid business plan, he can put down 10% (or $5,000) and get a loan from his local banker for the rest ($45,000). So, each year the lot fees from 5 occupied units would produce $6,000 income. The trailer payments for the five units for one year produce $15,000 income.
His mortgage payment is $600 a month, which totals $7,200 a year. After expenses the profits would be $13,800 for the year. Using the formula above Keith's ROI would be 276%, but this number does not take into consideration a few important things.
Over the last year, Keith's property has appreciated and is now worth $57,000. Second, the entire first year Keith owned the property he lived in the 6th trailer basically rent free. Finally, in the previous two examples, there was no underlying asset left over once all the profits had been produced. In this example profits were produced, but at the same time Keith's tenants were paying for an asset (the mobile home park) that Keith owns. So now in addition to profit, there is also equity and ownership of an appreciating asset.
The final point worth mentioning is that Keith was able to use the concept of leverage by getting a loan from the bank. This allowed Keith to put down %10 down on the total investment while he receives %100 of the profits.
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