RATE OF RETURN: HOW IT IS CALCULATED AND EXAMPLES - ECONOMY - 2024

The rate of return is the net profit or loss on an investment over a specified period of time, expressed as a percentage of the initial cost of the investment. The time period is usually one year, in which case it is called the annual return.

Investment gains are defined as income received plus capital gain from the sale of the investment. The rate of return is sometimes called return on investment or ROI.

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In finance, return is a return on an investment. It includes any change in the value of the investment and / or the cash flows that the investor receives from the investment, such as interest or dividend payments.

A loss rather than a gain is described as a negative return, assuming the amount invested is greater than zero.

To compare returns over time periods of different durations on an equal basis, it is useful to convert each return to an annualized return. This conversion process is called annualization.

What is the rate of return?

The rate of return can be applied to any type of investment, from real estate to bonds, stocks and works of art, as long as the asset that is purchased at any given time produces a cash flow in the future.

Applications

Rates of return are useful for making investment decisions. For nominal risk investments, such as savings accounts, the investor considers the effect of reinvesting. Thus, it increases savings balances over time to project expected future earnings.

For investments in which capital is at risk, such as stocks and home purchases, the investor also takes into account the effects of price volatility and the risk of loss.

The metrics that financial analysts use to compare a company's performance over time, or to compare performance across companies, are return on investment, return on equity, and return on assets.

In the capital budgeting process, companies compare the rates of return of different projects to decide which projects to pursue to maximize the company's return.

Real vs nominal rate of return

The rate of return used to purchase a home is considered a nominal rate of return. This is because it does not take into account the effect of inflation over time.

Inflation reduces the purchasing power of money. Therefore, the amount of the sale of the house in six years will not be the same as that same amount today. Similarly, the amount of the home purchase today is not worth the same as that same amount six years from now.

Discounting is a way of accounting for the value of money over time. Once the effect of inflation is taken into account, the rate of return will be called real, or adjusted for inflation.

How is it calculated?

The formula used to calculate the rate of return is as follows:

Rate of return = ((Final investment value - Initial investment value) / Initial investment value) x 100.

Taking into account the effect of time value of money and inflation, the real rate of return can also be defined as the net amount of cash flows received on an investment after adjusting for inflation.

The rate of return can be calculated for any investment, dealing with any type of asset.

Annualized rate of return

A concept closely related to the rate of return is the compound annual growth rate, or CAGR. This is the average annual rate of return on an investment over a certain period of time, greater than one year.

To calculate the compound annual growth rate, the value of an investment at the end of the period in question is divided by its value at the beginning of that period. Then the result is raised to the power of one divided by the length of the period. Finally one is subtracted from that result. This can be written as follows:

CAGR = ((Final value / Initial value) ^ (1 / Number of years)) - 1

Examples

Buying a home is a basic example for understanding how to calculate the rate of return. Let's say you buy a house for $ 250,000. Six years later, it is decided to sell the house. The family is growing and a bigger place is needed.

The house can be sold for $ 335,000, after deducting the realtor's taxes. The rate of return on buying and selling the home is: ((335,000-250,000) / 250,000) x 100 = 34%.

Now, what if the house was sold for less than it was paid for? Let's say it sells for $ 187,500. The same equation can be used to calculate the loss, or negative rate of return, on the transaction: (187,500-250,000) / 250,000 x 100 = -25%.

-ABC Company

Adam is a retail investor and decides to buy 10 shares of ABC Company at a unit price of $ 20. Adam holds shares in ABC Company for 2 years. During that period, ABC Company paid annual dividends of $ 1 per share.

After holding them for 2 years, Adam decides to sell the 10 shares of ABC Company at an ex-dividend price of $ 25. Adam would like to determine the rate of return during the two years that he owned the shares.

To determine the rate of return, you first calculate the amount of dividends you received over the two-year period: 10 shares x ($ 1 annual dividend x 2) = $ 20 in dividends of 10 shares

Then it is calculated how much the shares were sold for. 10 shares x $ 25 = $ 250 (profit from the sale of 10 shares).

Finally, it is determined how much it cost Adam to buy the 10 shares of ABC Company. 10 shares x $ 20 = $ 200 (cost of buying 10 shares)

Calculation of rate of return

Plug in all the numbers in the rate of return formula: (($ 250 + $ 20- $ 200) / $ 200) x 100 = 35%

Therefore, Adam earned a 35% return on his shares over the two-year period.

Annualized rate of return

Applying the formula, the annualized rate of return would be as follows: ((($ 250 + $ 20) / $ 200) ^ 1/2) - 1 = 16.1895%

Therefore, Adam earned an annualized rate of return of 16.1895% on his investment.

References

1. Investopedia (2018). Rate of Return. Taken from: investopedia.com.
2. Wikipedia, the free encyclopedia (2018). Rate of Return. Taken from: en.wikipedia.org.
3. CFI (2018). Rate of Return. Taken from: corporatefinanceinstitute.com.
4. Investing Answers (2018). Rate of Return. Taken from: investinganswers.com.
5. Joshua Kennon (2018). What Is a Good Return on Your Investments? The balance. Taken from: thebalance.com.