The most important thing an investor needs to understand is how to calculate their return on investment also known as their ROI. Even ROI can be computed differently and is sometimes broken down more specifically into the internal rate of return (IRR) or cash on cash return. I will briefly describe each and give very simple examples to help you grasp the concept. When calculating any of these, keep in mind every single expense you had while you were getting a return of your capital. This includes repairs, loan interest, insurance, commissions, fees, etc.
Your return on investment or ROI is the highest level calculation and is what I usually look at for a quick general view into what my investment returned. Keep in mind that ROI can also be negative. You can also compute your anticipated ROI when going into an investment based on your research and projections.
Example 1: Calculating ROI
Bought 100 shares of stock ABC at $10.00 per share. Sold 100 shares of ABC at $12.00 per share. The online broker's commission is $10 each time you buy or sell and you borrowed $1000 at 8% from another investor. This is known as a hard money loan. You held the investment for one year. Most people will simply see that they made $200 on $1000 and say they have a ROI of 20%. This is typically incorrect and too simplified. Here's the correct ROI calculation based on the example above:
Loan Interest $80
Total Investment $1100
ROI $1200-$1100 / $1100
So what on the surface looks like a 20% return, is actually a 9.1% return after you include the fees, interest and rebase your investment from $1000 to $1100.
Your IRR is also 9.1% since you held the investment for only one year. If you had held this investment longer, the IRR would be less. The IRR would be 4.6% over two years (9.1% divided by 2 years) if we pretend that you didn't accumulate more interest on the hard money loan you took out. We of course know this isn't the case in the real world and would have to re-compute the entire ROI.
My favorite part of investing is calculating the cash on cash return. This is where it can get fun! In the example above, you borrowed almost all the money for the investment. Your total cash invested is $20 in the form of the online broker's commission. At the end of the investment you have to repay the lender $1080 (the initial $1000 loan plus the 8% interest). This leaves you with $120. This means your cash on cash return is 500%! You multiplied your actual money five times!
Here's the calculation written out $120-$20 / $20.
Now that you understand ROI, IRR and cash on cash return, your investing will take on a new exciting life.