Investments refer to spending money on assets that will increase your money’s worth. But how do you assess if your investments are in the right direction? The most basic way of analysing the power of investments is to assess their yield. An investment is good if the return is higher than the cost spent on acquiring it.
In this article, let us talk about the assessment of investments through the concept of RoR. While RoR has different abbreviations in different contexts, the full form of RoR in finance is Rate of Return.
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What is the rate of return?
The rate of return is an indicator that suggests the profit or loss earned from an investment. It is ascertained as a percentage of the cost spent on making an investment. A positive rate of return suggests a profitable investment, while a negative return indicates an investment with a loss.
Why is the rate of return essential?
The rate of return is a crucial aspect of investing as it suggests whether the investment are useful or futile. It also helps in planning future investments accordingly.
Rate of return is also called the return on investment and applies to all kinds of investments. Whether we talk about purchasing financial assets like stocks and bonds, real estate assets like sites and houses, or other physical assets like machinery, the concept of calculating returns is relevant.
Analysing the rate of return helps investors make further decisions regarding the disposal of non-productive assets and increasing investments in productive assets.
How to calculate the rate of return on investments?
Rate of return formula = (Today’s market value of the investment – Initial amount invested) / Initial amount * 100
While this is the basic formula, the method of calculation may vary for some assets based on their features.
Consider physical assets like machinery, whose value will depreciate with time. Using the above formula in such cases will definitely show a negative rate of return, which may be misleading. In such situations, investors must calculate the return on investment based on the number of units produced by the machinery and the cash flow related to selling those units.
The prices of financial assets like stocks and bonds fluctuate based on market conditions. Apart from that, investors also benefit from cashflows like dividends and interest for stocks and bonds, respectively. Hence, investors should consider the difference in value as well as cashflows while calculating return on investments on such assets.
Example
A person invests in ₹25,00,000 in a real estate property. Five years later, the asset is worth ₹32,00,000.
So, the rate of return on this investment is:
= (32,00,000 – 25,00,000)/25,00,000 * 100
= 28%
Let us consider an example of investment in shares.
Trader A invests ₹10,000 to buy 100 shares of Company ABC at ₹100 each.
The market price of the share after five years is ₹600 per share, and trader A has earned a dividend of ₹1000 in 5 years.
His rate of return is:
= ([600*100] – 10000) + 1000) / 10000 * 100 = (51,000/10,000) * 100
= 510%
Also Read: What is CAGR and how to calculate? [ Explained]
Variations in calculating the rate of returns
There are various concepts that help investors analyse how their investments are performing. Here are some ways which use the basic idea of rate of return with some variations to analyse returns from different aspects:
- Average rate of return method (ARR)
Also called the annual average rate of return or accounting rate of return, this considers the average returns of an investment over its total life, against the initial cost of investments.
So, if an investor makes an investment for a period of 5 years, the return for each year is calculated and averaged out to determine the overall return on investment.
Accounting rate of return formula = Average profit or loss per year / Initial cost * 100
- Real rate of return
The basic rate of return generally considers the direct investment cost to returns. However, there are other costs related to investments. To ascertain the actual rate of return, it is essential that all the related costs are considered. Hence, the real rate of return shows the return on investments after deducting all related costs like tax, inflation rate, brokerage fees, etc.
Real rate of return = Rate of return – Other costs – Inflation rate
- Compound Annual Growth Rate (CAGR)
Year-on-year returns, especially in the case of mutual funds, are reinvested back with the initial investment. The absolute rate of return does not consider this factor.
So, to consider the effect of compounding and ascertaining the accurate rate of return each year, CAGR is used.
CAGR = [(Current value/ Initial cost) ^ (1/n)] – 1, where n is the investment tenure.
- Discounted Cash Flow (DCF)
The DCF method considers the time value of money. It uses cashflows to ascertain the value of investments.
DCF method helps in analysing the amount required today to earn a certain return in the future.
DCF = DCF = CF1 (1+r)1 + CF2 (1+r)2 + CFn (1+r)n, where CF determines cashflows.
- Yield to Maturity (YTM)
The YTM calculation is specific to ascertaining returns on debt instruments like bonds. It indicates the amount of returns earned until the bond’s maturity.
It considers the current value of the bond along with interest payments while calculating the overall return on investment.
YTM = {C + [(F-P)/n)]} / {(F + P)/2}, where
C = Interest, F = Face value, P = Present value, n = Number of years
Also Read: What is Yield to Maturity?
Bottomline
Ascertaining the return on investments is the key to investment decisions. It helps in analysing whether the investor has to withdraw the investment or increase it.
Hence, the knowledge of how to calculate it and its different methods is essential for all investors. Depending on the objective of the analysis, investors can choose from the different variants of the concept that best suit their requirements.
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