Financial Literacy
Comparing ROI and ROE
Return on investment (ROI) and return on equity (ROE) are two different ways to measure the performance and profitability of an investment. Both ROI and ROE are measurements used frequently to analyze stock market and real estate investments. A higher ROI and ROE is better. Beyond that, do you understand the major details and differences between the two measurements? It’s important to understand so that you can make good decisions when investing and track the performance of your investments. Here in this article, we compare ROI and ROE.
What is ROI
ROI is calculated using the net return, subtracting the “initial value of the investment” from the “final value of the investment”, divided by the initial value of the investment and multiplied by 100. This calculation is incredibly simple and gives a good idea of the gain/loss made on the investment in terms of a percentage. This term is very common in investing and is one of the most popular measurements of performance and efficiency. It is a handy equation to have in your toolkit when comparing investments to maximize your investing efficiency.
For Example:
You saved up $20,000 and decided to invest in the company Lemonade Co. You bought 2,000 shares listed at $10 per share. One year later, you sold the shares for $12.50.
ROI = ([($12.50 – $10.00) * 1000] ÷ ($10.00 * 1000)) * 100 = 25%
As such, your ROI on this investment was 25%.
What is ROE
ROE is an equation that calculates how much profit an investment can generate based on invested money. The basic formula is “net income” divided by “shareholder equity.” Net income is the amount of income, after subtracting the expenses and taxes that a investment generates for a given period. Shareholders’ equity (sometimes called Investor’s equity) is calculated using a companies total asset, after subtracting the total liabilities (debt) . The beginning and end of the period should be the same period during which the net income is earned. ROE can also be used to determine the efficiency of real estate investments.
For Example:
Earlier this year, you bought an investment apartment for $100,000 with $20,000 down payment and borrowed $80,000 in the form of a mortgage. You were successfully able to rent out the apartment and the annual cash flow was $10,000 after accounting for rental income, expenses and taxes. One year later, you decided to sell the apartment for $115,000.
ROE = ([$10,000+$115,000-$100,000] ÷ ($100,000-$80,000)) * 100 = 125%
As such, your ROE on this investment was 125%.
Why is It Important To Know The Difference?
They key difference between ROI and ROE is that ROE accounts for debt when considering an investment’s profitability. In the two examples above, both investment opportunities have an ROI of 25%. However, the ROE for the Lemonade Co. and investment apartment were 25% and 125% respectively. The reason why the investment apartment had a greater ROE is because of the $80,000 debt that was being leveraged.
Why is It Important To Know The Difference?
Both of these calculations should be a part of your research when considering investments. Whether you’re looking to invest in a company or real estate, both financial measurements can be strong indicators of an investment’s profitability.
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