What Is a Rate of Return (RoR)?
A rate of return (RoR) signifies the net gain or loss of an investment over a set period, expressed as a percentage of the investment’s starting cost. Calculating RoR determines the percentage change from the investment’s inception to its current value.
Key Highlights
- The RoR gauges the profit or loss of an investment over time.
- Useful for diverse assets including stocks, bonds, real estate, and art.
- Simple RoR calculations do not consider inflation, unlike the real rate of return.
- The internal rate of return (IRR) includes the time value of money.
Understanding a Rate of Return (RoR)
RoR is versatile, suitable for various investments like real estate, bonds, stocks, or fine art. It works provided you purchase the asset and it generates cash flow later on. Investors often use historical rates of return to assess investment attractiveness and can set a required rate of return before making choices.
RoR Formula
The formula to calculate RoR is:
1Rate of return = \[ (Current value - Initial value) / Initial value \] x 100
Alternatively, if time value and inflation are considered, it results in a more precise real rate of return.
RoR on Stocks and Bonds
Consider an investor buys a stock at $60 per share and owns it for five years, earning $10 in dividends. If they sell the stock at $80, their per-share gain is $20, plus $10 dividend income totaling a $30 gain. Hence, the rate of return is 50%.
For bonds, an investor buys a $1,000 par value 5% coupon bond and sells it at $1,100 after earning $100 in interest, resulting in a 20% rate of return.
Real Rate of Return vs. Nominal Rate of Return
A simple rate of return does not factor inflation, making it the nominal RoR. Discounting with inflation gives the real rate of return, adjusting the investment’s future value to present value.
Real RoR vs. Compound Annual Growth Rate (CAGR)
The CAGR represents an annual rate of return over several periods, accounting for compounded growth. It’s calculated by dividing the ending value by the beginning value, powering the result by 1 divided by the period length, and subtracting one.
Example of RoR
Imagine buying a house for $250,000. After six years, you sell it at $335,000. The simple RoR is 34%.
1Rate of return = (335,000 - 250,000) / 250,000 x 100 = 34%
If sold at $187,500, the RoR illustrates a loss:
1Rate of return = (187,500 - 250,000) / 250,000 x 100 = -25%
Internal Rate of Return (IRR) and Discounted Cash Flow (DCF)
Consider the time value of money using discounted cash flows at a 5% discount rate. For a $10,000 piece of equipment increasing $2,000 annual cash inflows over five years, the adjusted cash surpasses initial costs, indicating profitability. The IRR is the discount rate making net present value zero.
1IRR = NPV = \sum{\frac{Ct}{(1 + r)^t}} - C0 = 0
2\text{where } Ct \text{ denotes cash flows, } r \text{ is the discount rate, and } t \text{ the period.}
Alternatives to Rate of Return
- IRR: The discount rate making NPV zero.
- CAGR: Annual growth rate considering compound interest.
Drawbacks of RoR
The RoR doesn’t incorporate factors like the time value of money, timing/volume of cash flows, risk, or investment uncertainties.
What Is a Good Return on Investment?
Typically, a good investment return is around 7% per year, akin to the inflation-adjusted average annual return of the S&P 500.
Conclusion
RoR is a straightforward metric showcasing the net gain or loss over a period. While practical, it doesn’t consider finer financial details, unlike the IRR or CAGR handling time-value and compounded growth accurately.
Related Terms: Internal Rate of Return, Compound Annual Growth Rate, Discounted Cash Flow, Net Present Value.
