Investopedia/Jean Folger: How can return on investment (ROI) calculations be manipulated?

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How can return on investment (ROI) calculations be manipulated?
By Jean Folger
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Return on Investment (ROI) is a performance metric used to evaluate the financial efficiency of an investment, or to compare the relative efficiency of multiple investments. It measures an investment’s gain or loss relative to the initial investment. ROI is calculated as follows:

ROI = (earnings – cost of investment) / cost of investment * 100%

ROI typically appears as a percentage; for example, investment XYZ has a ROI of 10%. The ROI calculation is the same for every type of investment – whether it’s stocks, real estate, or collectibles. The calculation can be manipulated, however, in terms of how costs and returns are accounted for. For example, real estate investors can use either the cost method or the out-of-pocket method to determine ROI.

Assume a real estate investor buys a house for $150,000, puts $50,000 into it for repairs and renovations, and then sells the property for $250,000. The investor’s equity position in the property is $250,000 – ($150,000 + $50,000) = $50,000. If the investor uses the cost method, the ROI will be calculated by dividing the equity by all costs:

$50,000 / $200,000 *100% = 25% ROI

If the investor instead uses the out-of-pocket method, the ROI will be calculated taking into consideration the down payment amount instead of the purchase price. A 20% down payment on the $150,000 property would be equal to $30,000, and total costs would be limited to this down payment plus the $50,000 for repairs and renovations, or $80,000 total. With the value of the property at $250,000, the investor’s equity position in the property would be $250,000 – ($30,000 + $50,000) = $170,000. The ROI again is calculated by dividing the equity by all costs:

$170,000 / $80,000 *100% = 212% ROI

As the example shows, the ROI for similar investments can vary greatly, depending on how the value is calculated. In these examples, the out-of-pocket method allows the investor to use leverage (by financing the property) to increase the ROI. It would be important, however, to take into consideration the costs associated with the loan, as they will affect the bottom line. It’s also important to stick to one method if more than one investment is being evaluated; otherwise, the results will be misleading.
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