An asset’s return on investment (ROI) measures the total profit (or loss) expressed as a percentage of the investment’s cost basis. ROI is a useful financial metric; however, it does have some limitations.
The formula for calculating an investment’s ROI is the following:
ROI = [Final Value of Investment – Initial Cost Outlay] / Initial Cost Outlay
Investors can calculate ROI using amounts that are realized, unrealized, or a combination of both.
Let’s look at some examples.
Example ROI on Unrealized Gains on Stocks
John purchased $5,000 worth of stock in Company ABC on January 15, 2024. The stock pays no dividends or any other distributions. On April 15, 2024, the fair market value of his shares is now worth $5,650. John has not sold any of his shares. What is the ROI on John’s investment in Company ABC?
ROI = ($5,650 – $5,000) / $5,000
ROI = 0.13
John’s ROI on his stock is 13%. The gain is unrealized because he has yet to sell the position.
Example ROI on Realized Gains and Dividend Distributions
Adam purchased $10,000 worth of stock in Company Bravo on October 1, 2022. After holding the stock for over two years, Adam sold all of his shares for $12,500 on November 15, 2024, for a total capital gain of $2,500.
The stock paid regular quarterly dividends. Adam reviewed all of his brokerage statements, and the total dividends paid to him was $200. Adam wants to calculate the total ROI for his investment in Company Bravo.
Final Value of Investment = $12,500 + $200
Final Value of Investment = $12,700
ROI = ($12,700 – $10,000) / $10,000
ROI = 0.27
Adam’s total ROI is 27%, which consists of capital gains on the sale of the investment plus the dividend income received while holding the investment.
If Adam calculated his investment ROI using only the capital gains income, the ROI would be 25% instead of 27%. By including the dividend income as part of the overall investment return, he has a more accurate total ROI.