Last Updated on May 24, 2022 by Anjali Chourasiya
Rate of return is a crucial measure of financial and economic success. To calculate the minimum acceptable return on investment, investors worldwide rely upon this metric. Individuals, companies, and other finance professionals routinely use the rate of return while purchasing new products, equipment, or even during potential mergers, and it is extensively applied to a variety of investments from stocks and real estate to bonds and art.
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What is the rate of return?
Rate of return calculates the gain or loss of initial investment over a certain period. When you calculate the rate of return, you determine the change, in percentage form, from the beginning of the investment until the end.
To calculate it, overall market returns, risk-free rate of return, stock volatility, etc are considered. Rate of return doesn’t take into account the impact of inflation in the simple calculation.
How to calculate the rate of return?
The formula for rate of return is as follows:
Rate of return = [ (Current value of investment − Initial value of investment)]/Initial investment value ×100
For instance, assume you bought a share at Rs. 100. It eventually rose to Rs. 110.
Now, using the formula mentioned above, the calculation would be:
[(Rs. 110 – Rs. 100) ÷ Rs. 100] x 100 = 10
Now, if you sold the share, your investment would have a 10% rate of return.
Real rate of return vs nominal rate of return
A nominal rate of return or simple rate of return as it is commonly called does not consider the effect of inflation over time. Inflation causes a drop in the purchasing power of money. For the same reason, six years later, Rs. 100 will not have the same value as it does today.
When the effect of inflation is factored in, it is called the real rate of return or inflation-adjusted rate of return.
Inflation – adjusted return = (1 + Return / 1 + inflation) – 1
Rate of return on stocks and bonds
The formula for calculating the rate of return for stocks and bonds is slightly different.
Let’s suppose you buy a stock for Rs. 60 a share and own it for one year, during which you earn a total amount of Rs. 10 in dividend.
Assume you sold the stock for Rs. 80, then:
Total stock return = (End period stock price – Initial stock price) + Dividend / Initial stock price
Calculated as per formula: Rs. (80 – 60) + Rs. (10/60) = Rs. 30
Hence for this example, the return would be Rs. 30
Real rate of return vs compound annual growth rate
The simple rate of return and compound annual growth rate (CAGR) are closely related. The CAGR is the average yearly rate of return on an investment spanning longer than one year. While calculating CAGR for different years, growth over multiple periods has to be taken into account.
The formula for CAGR is as follows:
CAGR = [(Ending Value/Beginning Value) ^ (1/N)] – 1
where N = Time period
For example, assume the initial value of your investment at the beginning of the period in question is Rs. 15,000, and the final value at the end of three years is Rs. 25,000. Then, CAGR is calculated as:
CAGR = (25,000/15,000) ^ (⅓) – 1
CAGR = 7.16%.
Internal rate of return and discounted cash flow
One must be aware that the rate of return, over time, does not consider time value of money. Hence, a better alternative for businesses and investors is the discounted cash flow (DCF) method.
Discounted cash flows are comprehensive in a way that it considers the earnings on investment and discounts each of the cash flow generated against a discount rate.
The discount rate in simple words is the minimum rate of return acceptable to an investor. DCF method can be used to estimate the value of a stock, bond, business, company, and even equipment.
When you use the rate of return with a discounted cash flow, it is known as the internal rate of return (IRR). The IRR is a discount rate that makes the net present value (NPV) of all cash flows belonging to a particular investment or project equal zero. IRR calculations use the same formula as NPV does and apply money’s time value with interest.
Investment returns can be calculated using various formulas, rate of return being the most popular. Rate of return is used to calculate the returns on the initial investment. It helps to calculate gains or losses incurred by the investments over a period of time. One can use it also for comparison, along with other types of rate of return calculation such as CAGR, DCF, etc., to have a holistic view of their returns.
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