What is ROI? How to Calculate Return on Investment and CAGR
Return on Investment (ROI) is the most widely used metric in finance and business — yet it's frequently misused and misunderstood. Knowing how to calculate ROI correctly, and when to use its cousin CAGR (Compound Annual Growth Rate) instead, will help you make far better investment decisions.
What is ROI and how to calculate it
ROI measures how much you gained (or lost) relative to what you invested. The formula is straightforward: ROI = (Net Profit / Cost of Investment) × 100 Or equivalently: ROI = ((Final Value − Initial Value) / Initial Value) × 100 Example: you invest $10,000 in a stock. Two years later, it's worth $13,500. ROI = ($13,500 − $10,000) / $10,000 × 100 = 35% ROI tells you the total return regardless of how long it took. A 35% ROI is great — but is that over 2 years or 10 years? This is where ROI's limitation becomes clear.
What is CAGR and why it matters
CAGR (Compound Annual Growth Rate) answers the question ROI can't: "what was the equivalent annual return?" CAGR = (Final Value / Initial Value)^(1/n) − 1 Where n = number of years. Using the same example: $10,000 growing to $13,500 over 2 years. CAGR = ($13,500 / $10,000)^(1/2) − 1 = 1.35^0.5 − 1 = 16.2% per year CAGR is the standard metric for comparing investments of different durations. The S&P 500 10-year CAGR is approximately 12.9%. If an investment has a 10-year CAGR below 7%, it probably underperformed inflation-adjusted returns.
When to use ROI vs CAGR
Use ROI when: evaluating a completed project with a clear start and end point — buying and selling a property, the total profit on a business investment, or comparing two equal-duration options. Use CAGR when: comparing investments with different time horizons, evaluating fund performance, communicating investment returns in a normalized way, or projecting future portfolio values. Common mistake: comparing a 1-year 20% ROI against a 5-year 80% ROI without annualizing. The 1-year investment has a 20% CAGR; the 5-year has only 12.5% CAGR — the shorter investment actually won on an annualized basis.
Real estate ROI — a more complex example
Real estate ROI requires accounting for multiple factors: Purchase price: $350,000 Down payment: $70,000 (20%) Rental income (annual): $24,000 Expenses (taxes, insurance, maintenance): $8,000 Net operating income: $16,000 Cash-on-cash ROI = $16,000 / $70,000 = 22.9% per year After 5 years, property sells for $420,000: Total return = equity gain ($70,000) + net rental income ($80,000) − down payment ($70,000) = $80,000 profit on $70,000 invested Total ROI = 114%; CAGR = (170,000/70,000)^(1/5) − 1 = 19.4% per year
ROI limitations you need to know
ROI is powerful but has real blind spots: 1. No time value of money: a 50% ROI over 1 year is very different from 50% over 20 years, but ROI shows the same number. 2. No risk adjustment: two investments with 10% CAGR may have very different volatility. Risk-adjusted returns (Sharpe ratio) provide more context. 3. Excludes opportunity cost: comparing your investment's ROI against simply putting money in an S&P 500 index fund is essential context. 4. Selective periods: advisors often cherry-pick favorable start/end dates. Always ask "what's the 10 or 20-year CAGR?" rather than focusing on short-term returns.
Ferramenta relacionada
ROI Calculator