Table of Contents
- What Is a Rate of Return (RoR)?
- Understanding a Rate of Return (RoR)
- The Formula for RoR
- RoR on Stocks and Bonds
- Real Rate of Return vs. Nominal Rate of Return
- Real Rate of Return vs. Compound Annual Growth Rate (CAGR)
- Example of RoR
- Internal Rate of Return (IRR) and Discounted Cash Flow (DCF)
- Alternatives, Drawbacks, and What Makes a Good RoR
- The Bottom Line
What Is a Rate of Return (RoR)?
Let me explain what a rate of return, or RoR, really means for you as an investor. It's essentially a measure of how much your investment has grown or shrunk in value compared to what you originally paid for it. You're looking at the percentage change from the start to the end of the period. This applies to just about any asset you can think of, from stocks and bonds to something like fine art.
Understanding a Rate of Return (RoR)
You can use RoR for any investment, whether it's real estate, bonds, stocks, or even art, as long as you buy it at one time and it generates cash flow later. I assess investments partly based on their past RoR, comparing them to similar assets to see what's most appealing. Many of us set a required RoR before deciding to invest.
The Formula for RoR
Here's the straightforward formula for calculating RoR: Rate of return = [(Current value - Initial value) / Initial value] × 100. This is your basic growth rate, often called return on investment or ROI. If you factor in the time value of money and inflation, you get the real rate of return, which is the net discounted cash flows adjusted for inflation.
RoR on Stocks and Bonds
Calculating RoR for stocks and bonds differs a bit. Suppose you buy a stock for $60 per share, hold it five years, earn $10 in dividends, and sell for $80. Your gain is $20 from the sale plus $10 in dividends, totaling $30, divided by $60, giving you 50%. For a bond, if you pay $1,000 for a 5% coupon bond earning $50 yearly interest, sell for $1,100 with $100 total interest, your RoR is ($100 gain + $100 interest) / $1,000, or 20%.
Real Rate of Return vs. Nominal Rate of Return
The simple RoR is nominal because it doesn't consider inflation, which erodes purchasing power over time. To get the real rate, you discount for the time value of money and adjust for inflation, giving you a more accurate picture of your actual return.
Real Rate of Return vs. Compound Annual Growth Rate (CAGR)
CAGR is related but focuses on the average annual return over periods longer than a year, accounting for compounding. You calculate it by dividing the end value by the start value, raising to 1 over the number of periods, and subtracting 1.
Example of RoR
Take buying a house for $250,000 and selling it six years later for $335,000 after fees. Your RoR is [(335,000 - 250,000) / 250,000] × 100 = 34%. If you sell for $187,500 instead, it's -25%, showing a loss.
Internal Rate of Return (IRR) and Discounted Cash Flow (DCF)
To go further, consider the time value of money with IRR, which uses discounted cash flows. For instance, if a company buys equipment for $10,000 with 5% discount rate and gets $2,000 annual inflows for five years, you discount those flows. IRR is the rate making NPV zero, using the formula: IRR = NPV = ∑(Ct / (1+r)^t) - C0 = 0, where terms define periods, cash flows, and discount rate.
Alternatives, Drawbacks, and What Makes a Good RoR
Alternatives include IRR and CAGR, which handle time value and compounding better. Drawbacks of simple RoR are ignoring time value, cash flow timing, and risk. A good return is around 7% annually, matching the inflation-adjusted S&P 500 average.
The Bottom Line
In summary, RoR gives you the net gain or loss as a percentage of initial value over time. IRR shows annual growth with time value, and CAGR factors in compounding for annual rates.
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