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.
- The 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, the 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 lossNet LossNet loss or net operating loss refers to the excess of the expenses incurred over the income generated in a given accounting period. It is evaluated as the difference between revenues and expenses and recorded as a liability in the balance sheet..
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 soldCost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. is $ 55,000. now the 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 making investment decisions like purchasing new asset vs. replacement of asset, expansion of fixed assetFixed AssetFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples., diversification decision, mutually exclusiveMutually ExclusiveMutually exclusive refers to those statistical events which cannot take place at the same time. Thus, these events are entirely independent of one another, i.e., one event's outcome has no impact on the other event's result. 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 a 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 investmentsEquity InvestmentsEquity investment is the amount pooled in by the investors in the shares of the companies listed on the stock exchange for trading. The shareholders make gain from such holdings in the form of returns or increase in stock value.), return on investment, return on capital employed (it takes equity as well as debt into consideration to derive at return), etc.
This article 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 –