What’s the Rate of Return?
A rate of return is the gain or loss on an investment over a specified time period, expressed as a percentage of the investment’s cost. Gains on investments are defined as income received plus any capital gains realized on the sale of the investment. Rate of return can also be defined as the net amount of discounted cash flows received on an investment.
Rate Of Return – Summarized
A rate of return can be applied to any investment vehicle, from real estate to bonds, stocks and fine art, provided the asset is purchased at one point in time and produces cash flow at some point in the future. Investments are assessed based, in part, on past rates of return, which can be compared against assets of the same type to determine which investments are the most attractive.
The Differences Between Stocks and Bonds
The rate of return calculation for stocks and bonds is slightly different. Assume an investor buys a stock for $60 a share, owns the stock for five years, and earns $10 in total dividends. If the investor sells the stock for $80, he has a $20 per share gain and has earned another $10 in income. The rate of return for the stock is $30 per share divided by the $60 cost per share, or 50%.
On the other hand, if an investor pays $1,000 for a $1,000 par value 5% bond, the investment earns $50 in interest income per year. If the investor sells the bond for $1,100 and earns $100 in total interest, the investor’s rate of return is the $100 gain plus $100 interest income divided by the $1,000 cost, or 20%.
How to Discount Cash Flows
Discounted cash flows take the earnings on an investment and discount each of the cash flows based on a discount rate. The discount rate represents a minimum rate of return acceptable to the investor, or an assumed rate of inflation. In addition to investors, businesses use discounted cash flows to assess the profitability of a company’s investment.
Assume, for example, a company is considering the purchase of a new piece of equipment for $10,000 and the firm uses a discount rate of 5%. After a $10,000 cash outflow, the equipment increases cash inflows by $2,000 a year for five years. The business applies present value table factors to the $10,000 outflow and to the $2,000 inflow each year for five years. The $2,000 inflow in year five would be discounted using the discount rate at 5% for five years. If the sum of all of the adjusted cash inflows and outflows is greater than zero, the investment is profitable. A positive net cash inflow also means the rate of return is higher than the 5% discount rate.
Understanding Total Returns
Total return, when measuring performance, is the actual rate of return of an investment or a pool of investments over a given evaluation period. Total return includes interest, capital gains, dividends and distributions realized over a given period of time.
Total return accounts for two categories of return: income including interest paid by fixed-income investments, distributions or dividends and capital appreciation, representing the change in the market price of an asset.
Total Return – Summarized
Total return is the amount of value an investor earns from a security over a specific period, typically one year, when all distributions are reinvested. Total return is expressed as a percentage of the amount invested. For example, a total return of 20% means the security increased by 20% of its original value due to a price increase, distribution of dividends (if a stock), coupons (if a bond) or capital gains (if a fund). Total return is a strong measure of an investment’s overall performance.
Example of Total Return
An investor buys 100 shares of Stock A at $20 per share for an initial value of $2,000. Stock A pays a 5% dividend the investor reinvests, buying five additional shares. After one year, the share price rises to $22. To calculate the investment’s total return, the investor divides the total investment gains (105 shares x $22 per share = $2,310 current value – $2,000 initial value = $310 total gains) by the initial value of the investment ($2,000) and multiplies by 100 to convert the answer to a percentage ($310/$2,000 x 100 = 15.5%). The investor’s total return is 15.5%.
Importance of Total Return
Some of the best dividend stocks have small growth potential and produce small capital gains. Basing an investment’s return on capital gains alone does not take into consideration price increases or other methods of growing the stock’s value. For example, an investor buys shares of Company B, and the share price increases 24.5% in one year. The investor gains 24.5% from the price change alone. Since Company B also paid a dividend during the year, adding in the stock’s yield of 4.1% to the price change, the combined return is 28.6%.
Total return determines an investment’s true growth over time. It is important to evaluate the big picture and not just one return metric when determining an increase in value. Total return is used when analyzing a company’s historical performance. Calculating expected future return puts reasonable expectations on an investor’s investments and helps plan for retirement or other needs.