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# 1/28/2017 CapitalizationOfEarnings

## Return On Investment - ROI

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## What is 'Return On Investment - ROI'

HowToCalculateReturnOnInvestment(ROI)
A performance measure used to evaluate the efficiency of an investment or
to compare the efficiency of a number of different investments. ROI
measures the amount of return on an investment relative to the investments
cost.. To calculate ROI, the benefit (or return) of an investment is divided by
cost
the cost of the investment, and the result is expressed as a percentage or a
ratio.

The return on investment formula:
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## In the above formula, "Gain from Investment refers to the proceeds

obtained from the sale of the investment of interest. Because ROI is
measured as a percentage, it can be easily compared with returns from other investments, allowing
one to measure a variety of types of investments against one another.

## BREAKING DOWN 'Return On Investment - ROI'

Return on investment is a very popular metric because of its versatility and simplicity. Essentially,
return on investment can be used as a rudimentary gauge of an investments profitability. ROI can
be very easy to calculate and to interpret and can apply to a wide variety of kinds of investments.
That is, if an investment does not have a positive ROI, or if an investor has other opportunities
available with a higher ROI, then these ROI values can instruct him or her as to which investments
are preferable to others.

For example, suppose Joe invested \$1,000 in Slice Pizza Corp. in 2010 and sold his shares for a total
of \$1,200 a year later. To calculate the return on his investment, he would divide his profits (\$1,200 -
\$1,000 = \$200) by the investment cost (\$1,000), for a ROI of \$200/\$1,000, or 20%.

With this information, he could compare the profitability of his investment in Slice Pizza with that of
other investments. Suppose Joe also invested \$2,000 in Big-Sale Stores Inc. in 2011 and sold his
shares for a total of \$2,800 in 2014. The ROI on Joes holdings in Big-Sale would be \$800/\$2,000, or
40%. Using ROI, Joe can easily compare the profitability of these two investments. Joes 40% ROI
from his Big-Sale holdings is twice as large as his 20% ROI from his Slice holdings, so it would appear
that his investment in Big-Sale was the wiser move.

Limitations of ROI
Yet, examples like Joe's reveal one of several limitations of using ROI, particularly when comparing
investments. While the ROI of Joes second investment was twice that of his first investment, the
time between Joes purchase and sale was one year for his first investment and three years for his
second. Joes ROI for his first investment was 20% in one year and his ROI for his second investment
was 40% over three. If one considers that the duration of Joes second investment was three times
as long as that of his first, it becomes apparent that Joe should have questioned his conclusion that
his second investment was the more profitable one. When comparing these two investments on an
annual basis, Joe needed to adjust the ROI of his multi-year investment accordingly. Since his total
ROI was 40%, to obtain his average annual ROI he would need to divide his ROI by the duration of his
investment. Since 40% divided by 3 is 13.33%, it appears that his previous conclusion was incorrect.

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While Joes second investment earned him more profit than did the first, his first investment was
actually the more profitable choice since its annual ROI was higher.

Examples like Joes indicate how a cursory comparison of investments using ROI can lead one to
make incorrect conclusions about their profitability. Given that ROI does not inherently account for
the amount of time during which the investment in question is taking place, this metric can often be
used in conjunction with Rate of Return,
Return, which necessarily pertains to a specified period of time,
unlike ROI. One may also incorporate Net Present Value (NPV),
(NPV), which accounts for differences in the
value of money over time due to inflation, for even more precise ROI calculations. The application of
NPV when calculating rate of return is often called the Real Rate of Return.
Return.

Keep in mind that the means of calculating a return on investment and, therefore, its definition as
well, can be modified to suit the situation. it all depends on what one includes as returns and costs.
The definition of the term in the broadest sense simply attempts to measure the profitability of an
investment and, as such, there is no one "right" calculation.

For example, a marketer may compare two different products by dividing the gross profit that each
product has generated by its associated marketing expenses
expenses.. A financial analyst, however, may
compare the same two products using an entirely different ROI calculation, perhaps by dividing the
net income of an investment by the total value of all resources that have been employed to make
and sell the product. When using ROI to assess real estate investments
investments,, one might use the initial
purchase price of a property as the Cost of Investment and the ultimate sale price as the Gain
from Investment, though this fails to account for all of the intermediary costs, like renovations,
property taxes and real estate agent fees.

This flexibility, then, reveals another limitation of using ROI, as ROI calculations can be easily
manipulated to suit the user's purposes, and the results can be expressed in many different ways. As
such, when using this metric, the savvy investor would do well to make sure he or she understands
which inputs are being used. A return on investment ratio alone can paint a picture that looks quite
different from what one might call an accurate ROI calculationone incorporating every relevant
expense that has gone into the maintenance and development of an investment over the period of
time in questionand investors should always be sure to consider the bigger picture.

Developments in ROI
Recently, certain investors and businesses have taken an interest in the development of a new form
of the ROI metric, called "Social
"Social Return on Investment,"or
Investment,"or SROI. SROI was initially developed in the
early 00's and takes into account social impacts of projects and strives to include those affected by
these decisions in the planning of allocation of capital and other resources.

## For a more in-depth look at ROI, see:FYI

see:FYI on ROI: A Guide to Calculating Return on Investment.
Investment.

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Capitalization Of Earnings
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## Capitalization of earnings is a method of determining the value of an organization by calculating the

net present value (NPV) of expected future profits or cash flows.
flows. The capitalization of earnings
estimate is determined by taking the entity's future earnings and dividing them by the capitalization
rate (cap rate). This is an income-valuation approach that determines the value of a business by
looking at the current cash flow,
flow, the annual rate of return and the expected value of the business.

Where:
d = discount rate

g = growth rate

## BREAKING DOWN 'Capitalization Of Earnings'

The capitalization of earnings approach helps investors determine the potential risks and return of
purchasing one company rather than another to decide which may offer the best value for the
investor's money. For example, imagine a small business has been bringing in \$500,000 annually for
the past decade and most likely should continue to do so. The business pays \$100,000 annually in
expenses. Therefore, the business earns \$400,000 annually (\$500,000 - \$100,000 = \$400,000.)
Because the company should retain its value, a buyer is most likely able to sell it for the same price
as what he paid. The buyer could then compare this low-risk investment earning \$400,000 annually
to other ways he may earn the same amount. For example, he may invest in a treasury bill paying
6% annually. To earn the same \$400,000 per year, the buyer has to invest approximately \$6.7 million
in treasury bills (6,700,000 x 6% = \$402,000.) Using this valuation, the small business is worth about
\$6.7 million.

## Determining a Capitalization Rate

over time and Markets
have various
expenses and risks, the higher the perceived risk, the higher the capitalization rate that is used in
determining a companys value. Rates typically used for small businesses are 20% to 25%, which is Search news, tickers, terms Newsletters
the return on investment (ROI) buyers typically look for when deciding which company to purchase.

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Return
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Video Definition

A return is the gain or loss of a security in a particular period. The return consists of the income and
the capital gains relative on an investment, and it is usually quoted as a percentage. The general rule
is that the more risk you take, the greater the potential for higher returns and losses.

Return is also used as an abbreviation for income tax return see 1040 Form.
Form.

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BREAKING DOWN 'Return'
While some investors will settle for principal protection, most investors are in search of return,
Return On Investment
specifically Topics
- ROI Alpha returns
alpha returns. Reference
are generated when anAdvisors Markets moreSimulator
investment generates money
than it costs. In general, there are three different types of return measures: return on investment,
investment,
return on equity and return on assets. Each one is essentially calculated the same way, but the Search news, tickers, terms Newsletters
Capitalization Of Earnings
inputs have different labels.

Return

Investment Center

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Average Return

Cash-On-Cash Return

Pig

Investing

Asset Redeployment

Opportunity Cost

Investment Center
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A business unit that can utilize capital to directly contribute to a company's profitability. Companies
evaluate the performance of an investment center according to the revenues it brings in through
investments in capital assets compared to the overall expenses.

## BREAKING DOWN 'Investment Center'

An investment center is different than a cost center,
center, which indirectly adds profit and is evaluated
according to the money it takes to operate. Moreover, unlike a profit center,
center, investment centers can
utilize capital in order to purchase other assets. Because of this complexity, companies have to use a
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variety of metrics, including return on investment (ROI), residual income and economic value added
(EVA) to evaluate performance.
Return On Investment - ROI Topics Reference Advisors Markets Simulator
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Capitalization Of Earnings
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Investment Center

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Average Return

Cash-On-Cash Return

Pig

Investing

Asset Redeployment

Opportunity Cost

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Average Return
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Average return is the simple mathematical average of a series of returns generated over a period of
time. An average return is calculated the same way a simple average is calculated for any set of
numbers; the numbers are added together into a single sum, and then the sum is divided by the
count of the numbers in the set. There are many return measures; two of the most popular are
return on assets (ROA) and return on equity (ROE).

## BREAKING DOWN 'Average Return'

One example of average return is the simple mathematical average. For example, suppose an
investment returns the following annual returns over a period of five full years: 10%, 15%, 10%, 0%
and 5%. To calculate the average return for the investment over this five-year period, the five annual
returns are added together and then divided by 5. This produces an annual average return of 8%.
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In business, there are three main ways to calculate return. One way is with a simple growth formula,
Return
whereOn
theInvestment - ROIinvestmentTopics
return on the is a functionReference
other two measures Simulator
ROA
and ROE, focus on performance rather than growth.
Capitalization Of Earnings

Return

Investment Center

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Average Return

Cash-On-Cash Return

Pig

Investing

Asset Redeployment

Opportunity Cost

Cash-On-Cash Return
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Video Definition

Cash-on-cash return is a rate of return often used in real estate transactions that calculates the cash
income earned on the cash invested in a property. For example, when an investor purchases a rental
property, she might put down only 10% for a cash down payment.
payment. Cash-on-cash return measures
the annual return the investor made on the property in relation to the down payment only.

## BREAKING DOWN 'Cash-On-Cash Return'

Cash-on-cash return is a metric normally used to measure commercial real estate investment
performance. It is sometimes referred to as the cash yield on a property investment. The cash-on-
cash return rate provides business owners and investors with an analysis into the business plan for a
property and the potential cash distributions over the life of the investment.

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UP
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Return

Investment Center

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Average Return

Cash-On-Cash Return

Pig

Investing

Asset Redeployment

Opportunity Cost

Pig
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An investor who is often seen as greedy, having forgotten his or her original investment strategy to
focus on securing unrealistic future gains. After experiencing a gain, these investors often have very
high expectations about the future prospects of the investment and, therefore, do not sell their
position to realize the gain.

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BREAKING DOWN 'Pig'
Like a pig in the farmyard that overindulges in feed, this type of investor will hold onto an
investment
Return even after
On Investment a substantialTopics
- ROI movement in the hope thatAdvisors
Reference the investment will provideSimulator
Markets even
greater gains.

## Search news, tickers, terms Newsletters

Capitalization
For example,Of Earnings
suppose Joe invests in XYZ Corp. because the stock is undervalued
undervalued.. After the stock
doubles its price in two months, Joe holds on to the whole investment, hoping that it will double
again in the next two months, instead of selling a portion of the investment to realize a gain. Joe is,
Return
therefore, a piggish investor because he is greedy for huge gains and he allows his greed to
supersede his original value investment strategy.
Investment Center

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