What Is The Rate Of Return And How To Calculate It?

The rate of return, or as we popularly call it, the RoR, is the net profit or loss incurred on an investment over a given time period. It is expressed in a percentage of the initial cost of the investment. While calculating the RoR, you determine the change in percentage from the initial period until the end.

When the RoR is positive, you may consider it to be a gain. At the same time, a negative rate of return is the reflection of loss upon the investment.

Key Takeaways 

• The rate of return, or the RoR, is a tool that measures the profits or losses of any investment over a time period.

• The metric of RoR is used for a number of assets. It goes from stocks, real estate, bonds, and art.

• The inflation effects will not be counted in the simple calculation of the RoR. However, they are taken into account for real RoR calculation.

• The internal RoR considers the time value of money.

Let’s Understand the Rate Of Return 

The rate of return, or the RoR, is applicable to literally every investment tool. It starts from bonds to real estate, stocks, and even art. The RoR operates with every asset, given the asset was purchased at a given point in time, and it gives a cash flow at some time in the future.

Investments are generally assessed based partly on past return rates, which may be compared against the assets that are of a similar kind to help determine which of the investments are the most attention-grabbing. Many investors prefer picking a required RoR before they make a choice of investment.

How Can You Calculate The Rate Of Return?

The formula used to calculate the RoR is:

Rate of Return = [ Current Value – Initial Value/ Initial Value] X 100

This is the formula for the simple RoR calculation. It is also known as the basic growth rate or the return on investment. If you are also considering the effect of the time value of inflation and money, the real RoR may as well be defined as the net amount of the discounted cash flows. You get this calculation on the amount you receive on an investment after adjusting the inflation.

Rate Of Return On Bonds And Stocks 

The calculation of the RoR for bonds and stocks is a little different. Let’s assume that an investor is buying a stock for $60 per share, keeps the stock for over five years, and gains a total of $10 in dividends.

Now, if the investor is selling the stock for $80, his gain per share will be $80 – $60, which is $20.

Additionally, he will also be earning $10 in dividend income for a total profit of $20 + $10 = $30.

The RoR for that stock will then be $30 profit for a share, which is divided by the cost share of $60, or 50%.

On the other side, think of an investor who is paying $1,000 for a $1,000 par value of a 5% coupon bond. The investment, therefore, earns $50 in interest income every year. If the investor is selling the bond for a total of $1,100 in a premium value and profits $100 in the total interest, the RoR of the investor will then be gaining $100 on the sale. Also, he will earn $100 income interest, which is divided by the initial cost of $1,000, or 20%.

Rate Of Return And Nominal Rate Of Return

The simple rate of return is the nominal RoR as it does not account for the inflation effect over a time period. Inflation lowers the purchasing power of money. Therefore, an amount that holds a certain value today will not have the same value ten years later.

Discounting is one of the ways to account for money’s time value. Once that effect of inflation is taken into consideration, we may call it the real RoR.

Rate Of Return And Compound Annual Growth Rate

The compound annual growth rate is a concept that has a very close relation with the simple rate of return. The compound annual growth is a mean annual RoR over an investment for a specific time period that is beyond one year. This means the calculation should factor in the growth over a number of periods.

To be able to calculate the annual growth rate, we need to divide the value of an investment at the end of that period by its initial value, increase the result to the value of one divided by the count of holding periods like years, and deduct one the result you get.

Example Of RoR

You may calculate the RoR for any investment while dealing with assets of any kind. Let us take the example of buying a home to basically understand how you may calculate the RoR. Assume you purchase the house for $250,000. For easy understanding, let’s say you pay the total amount in cash.

After six years, you think of selling the house due to multiple reasons, like you need to move to a bigger place because your family is growing. You will be able to sell the property for $335,000 after subtracting any realtor’s taxes and fees.

The calculation for the simple RoR for this transaction goes as follows:

(335,000 – 250,000)/ 250,000 X 100 = 34%

Now, let us assume that you sold the house for a lesser amount than what you initially paid for it, maybe $87,000. In that case, you may apply the same formula to be able to calculate the loss or the negative RoR for this transaction:

(187,000 – 250,000)/ 250,000 X 100 = -24%

Frequently Asked Questions!! (FAQs)

The Bottom Line

The rate of return is a basic metric that gives the net profit or loss over an investment or a project over a given time period. The RoR is a percentage of the initial value.

The internal rate of return helps measure the performance of the projects or the investments. On the other hand, the RoR gives you the total growth since the beginning of the project.

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