What is the Rate of Return on Investment?
Rate of Return on Investment refers to the rate with which the company generates return from the investment during a period when compared with the cost of the investment made by the company and it is calculated by dividing the return on investment during the period by the cost of the investment.
In simple words, it is income earned by investing in assets and it is measured mostly in percentage terms. It can be negative (net loss) or positive (net gain) and measured periodically like quarterly, monthly or yearly.
- Rate of Return on investment is the first and foremost criterion one evaluates before investing decisions. It is just the extra earning over and above the investment made or decrease in the cost of investment over a period of time.
- For entities whose debt or equity stock is listed on recognized stock exchanges, the return on investment is very useful from the investor’s point of view.
Rate of Return on Investment Formula
However, it can be broken down into the following main 2 components:
(by this formula return can be derived in terms of percentage of the cost of investment)
- Current Value (Value on the date of sale of investment) – also known as market price, total revenue to date, net realizable value, etc.
- Initial Cost of acquisition – Amount paid for acquisition of investment).
Let us look at some of the simple to advanced examples to understand this concept in detail –
Let us assume that Mr. X bought shares of Apple Inc at say $170 on 01/01/2019. After a few months, Mr. X wants to sell the shares at the market price of Rs. $180.
Rate of return on investment = $(180-170)X100/ 170 that comes to 5.88% net gain.
If the sales price is Rs. 160 then the return will be = 160-170 X 100/ 170 = -5.88% net loss.
Now assume Mr. Y bought 100 Equity shares of Apple Inc. on 01/01/2019 for $ 170. So total initial cost = $17,000. After 3 tears, say on 01/01/2021, Mr. Y sells those shares at $ 182.
Rate of return on investment calculation for Mr. Y = 182 – 170/170 * 100 = 7.06%
It is clear from the above example that Mr. Y earns more in percentage terms. However, Mr. Y will get this amount after 3 years or so whereas Mr. X can get within a year which is more valuable than to receive after 3 years. If the Time value of money is considered the return of Mr. Y will get discounted by a certain factor and the final answer will be lower than 7.06%.
Sometimes the decision taken based on a just rate of return on investment can be futile. One must analyze each and every parameter before jumping to a conclusion.
Mr. A bought a property in the year 2011 for $ 100,000 and in the year 2019, the said property is sold for $ 200,000.
Rate of return on investment in property calculation as = 200,000 – 100,000/100,000 * 100 = 100%
In the case of the Manufacturing business, Return on Investment = Revenue – Cost of goods sold divided by the cost of goods sold.
Mr. B owns a company which is into manufacturing of steel wherein gross receipts are $100,000 and other income is $ 5,000. So the total revenue is equal to $105,000. The cost of goods sold is $ 55,000. now Rate of return on investment calculation can be done as follows:
= $105,000 – $55,000 / 55,000 * 100 = 90.91%.
Investment can be in Securities (Equity, Preferred, Bonds, Debentures, etc) for example:
Mr. D purchased non-convertible 5% bonds of XYZ incorporation for $ 100. after holding the bonds for the period of 2 years Mr. D decides to sell it at $ 150.
= ($150 – $100 / 100) * 100 = 50%.
- The calculation of the rate of return on investment is very easy and can be calculated in no time.
- Being a simple model, not much data is required to arrive at a rate.
- It can be measured for any type of investment like real estate, equity stock, preferred stock, etc.
- Expert knowledge is not required even any layman can calculate what is in it for her/him.
- It helps in calculating return in very little time and cost.
- Helps in taking investment decisions like purchasing new asset vs replacement of asset, expansion of fixed asset, diversification decision, mutually exclusive decision.
There is one main disadvantage or limitation is that formula as mentioned above does not account for the time value of money. The return in the above example might be generated after 2 or 3 years. so if 5.88% net gain is earned within one year has more value than if earned after 2-3 years. So, the time value factor is completely ignored in the formula.
It is a good tool to calculate overall benefit or return on investment however it is not reliable if the investment horizon period is beyond one year as it does not account for the time value of money. Even a layman can derive the rate of return on investment and can make an informed decision however one must consider the time value of money while arriving at the final decision. There are other measures from which correct return on investment can arrive, for example, return on equity (which measures income generated in equity investments), return on investment, return on capital employed (it takes equity as well as debt into consideration to derive at return), etc.
This has been a guide to what is Rate of Return on Investment and its definition. Here we discuss components, formula, and the calculation of the rate of return on investment along with practical examples. Here we also discuss the advantages and disadvantages. You can learn more about from the following articles –