Rate of Return on Investment

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

They can be measured in different terms like return on capital employedReturn On Capital EmployedReturn on Capital Employed (ROCE) is a metric that analyses how effectively a company uses its capital and, as a result, indicates long-term profitability. ROCE=EBIT/Capital Employed.read more, return on equityReturn On EquityReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit.read more, etc.

However, it can be broken down into the following main 2 components:

#1 – Rate of Return on Investment = (Current / Market or Sales Value – Initial Cost / Initial Cost) * 100

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For eg:
Source: Rate of Return on Investment (wallstreetmojo.com)

(by this formula, the return can be derived in terms of percentage of the cost of investment)

or

#2 – Return on Investment = Total Investment / Total Cost (by this formula, how many times the current value of the investment is compared to the cost of investment)

Examples

Let us look at some of the simple to advanced examples to understand this concept in detail –

You can download this Rate of Return on Investment Excel Template here – Rate of Return on Investment Excel Template

Example #1

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 Example 1

Rate of return on investment = $(180-170)X100/ 170 that comes to 5.88% net gain.

Rate of Return on Investment Example 1.1

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.read more.

Example #2

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.

Example 2

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.

Example #3

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.

Example 3

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.

Example #4

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. read more is $ 55,000. now the Rate of return on investment calculation can be done as follows:

Example 4

= $105,000 – $55,000 / 55,000 * 100 = 90.91%.

Example #5

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.

Example 5

= ($150 – $100 / 100) * 100 = 50%.

Advantages

Disadvantages

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.

Conclusion

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 moneyTime Value Of MoneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.read more. 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.read more), return on investment, return on capital employed (it takes equity as well as debt into consideration to derive at return), etc.

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