The rate of return, often called just the ‘return’, in the world of investments is the profit or loss you make on an investment – this is generally expressed as a yearly percentage. It is the ratio of the investment’s income over the cost of that investment. Rate of return is a way we measure financial or economic success. You could calculate it by expressing the economic gain – profit – as a percentage of the capital used to produce that gain. It could also be defined as the net amount of discounted cash flows obtained on an investment.
Any type of investment vehicle, including stocks, fine art, bonds, exchange-traded funds (EFTs), or real estate can yield a rate of return, as long as that asset is bought at one point in time and produces cash flow at a future point in time.
When trying to determine which investments are the most attractive, we usually compared their past rates of return.
If you had 200 shares, with a starting price of $12, the starting value would be 200 x 12 = $2,400. You then collected 0.50 per share in dividends, and the ending share price was 11.70, then at the end you would have 200 x 0.50 = $100 in cash, plus 200 x 11.70 = $2,340 in shares, totaling a final value of $100 + $2,340 = $2,440. The change in value was $2,400 minus $2,340 = 60. So, the return was 60 ÷ 2000 = 3%.
When you lose money on an investment, it is called a negative return.
According to lexicon.ft.com, the Financial Times’ glossary of terms, rate of return is:
“The profit on an investment, normally expressed as an annual percentage. This is typically the ratio of the income from the investment over the cost of the investment.”
Return on equity vs. rate of return
– Return on equity: often referred to as ROE, is a measure of how much cash a commercial enterprise can generate with each dollar of stockholder’s equity it receives. Return on equity tells us how investor dollars have been and are being used.
We calculate return on equity by taking a firm’s net income and dividing it by stockholder’s equity. Imagine John Doe Inc. generated $10 million in net income over the course of one year, and its shareholder’s equity during that period was $20 million.
If I buy this investment vehicle, I think I will earn about 6% per year on it, that is my expected rate of return. I won’t accept anything that gives me less than 5% annually, that is my required rate of return. When I have sold it, I’ll know its actual rate of return.
In this case, the ROE would be 10 million ÷ 20 million = 50%. In other words, John Doe Inc. generated $0.50 of profit for every stockholder dollar invested.
– Rate of Return: is the loss or gain on an investment over a set period – usually one year. We can apply rate of return to virtually any type of investment we make, from mutual funds to stocks to bonds.
When deciding where to invest their money, savers and investors rely on the rate of return of different investment vehicles. The most enticing investments are those with the highest historical rates of return.
Rate of return of stocks vs. bonds
The rate of return of a stock and that of a bond are calculated differently. Imagine you bought a stock for $50 per share, and after five years they earned you $15 in dividends.
If you sold that share for $90, you would have $40 per share gain plus $15 in income. The rate of return of that stock would be the total gain plus income ($55) divided by the $50 cost per share, which would equal 110%.
Now imagine you paid $2,000 for a $2,000 par value 6% bond – the investment would earn you $60 interest annually. If you sold the bond for $2,200 and earned $300 in total interest, your rate of return would be the $200 gain plus $300 interest income divided by the $2000 you paid for the bond, or 25%.
The IRR (internal rate of return) or ERR (economic rate of return) is used in capital budgeting to determine the expected growth rate of an investment.
Video – calculating rate of return
This eHow video explains what the rate of return is using simple examples and easy-to-understand language.