Real Rate of Return Formula

Real Rate of Return Formula (Table of Contents)

• Real Rate of Return Formula
• Real Rate of Return Formula Calculator
• Real Rate of Return Formula Template

Real Rate of Return Formula

Real rate of return formula helps an investor find out what actually he gets in return for investing a specific sum of money in an investment.

For example, if Mr Timothy invests $1000 into a bank and bank promises to offer 5% rate of return, Mr Timothy may think that he is getting a good return on his investment. In financial terminology, we will call this 5% as nominal rate.

However, the question remains, is 5% the actual return on Mr Timothy’s investment? The answer is no. We also need to consider inflation and also tax (if the return on investment is not tax deductible).

By considering the inflation rate, we can calculate the real rate of return. Here’s the formula –

Example of Real Rate of Return Formula

Let’s take a simple example to illustrate the real rate of return formula.

Ms. Soul has kept $100,000 in a bank. The bank promises to pay 6% rate of return at the end of the year. The inflation rate is 3% during the year. What would be the real rate of return?

By using the formula of real rate of return, we get –

• Real Rate of Return = (1 + Nominal Rate) / (1 + Inflation Rate) – 1
• Or, Real Rate of Return = (1 + 0.06) / (1 + 0.03) – 1
• Or, Real Rate of Return = 1.06 / 1.03 – 1
• Or, Real Rate of Return = 0.0291 = 2.91%.

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Explanation of Real Rate of Return Formula

Let’s look into the formula of the real rate of return.

In this formula, we’re first considering the nominal rate and then we will consider the inflation rate.

As you already know – the rate of return on the investment or the bank offers is the nominal rate of return. However, to find out the inflation rate, we need to use the consumer price index. Alternatively, the businesses can use a different consumer price index to calculate the inflation or they can only take the goods and services into account that are related to their business.

Here’s the formula by using which we can find out the inflation rate –

Rate of Inflation = (CPI _x+1 – CPI _x) / CPI _x

Here, CPI _x means initial consumer index.

If you have invested a good amount, it’s always prudent to use the real rate of return to see how much you’re actually earning on the investment.

However, if you just want to make sure how much you’re actually making in a casual sense, you can just use the following formula – (nominal rate – inflation rate).

Though this formula is not recommended, you can just check before going into detail.

Use of Real Rate of Return Formula

As you can see already, the real rate of return is quite useful to the investors.

If the investors want to know how much they are actually making (in some cases it is actually negative), In this formula is a good one.

However, there are two things you need to consider before using this formula.

• The first thing is to deduct the inflation rate (or to divide the inflation rate); you need to make sure that you will purchase the same goods the CPI considers.
• The second thing is the rate of return is not always accurate. Yes, you can calculate the real rate of return by using the formula, but there can be more factors that you may need to consider e.g. taxes, opportunity cost etc.

Real Rate of Return Calculator

You can use the following Real Rate of Return Calculator.

Real Rate of Return in Excel (with excel template)

Let us now do the same example above in Excel. This is very simple. You need to provide the two inputs of Nominal Rate and Inflation Rate.

You can easily calculate the real rate of return in the template provided.

Recommended Articles

This has been a guide to Real Rate of Return formula, its uses along with practical examples. Here we also provide you with Real Rate of Return Calculator with downloadable excel template. Here are the other suggested articles –

• What is the Nominal Rate of Return?
• Formula to Calculate Rate of Return
• Opportunity Cost Formula
• ROAA Formula
• Return on Average Equity
• ROA Calculator 
• Return on Invested Capital Formula