What is the Rate of Return on Investment?

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, 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 earnings over and above the investment made or the decrease in the investment cost over some 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 break down into the following main two components:

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

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(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 valueNet Realizable ValueNet Realizable Value is a value at which the asset may be sold in the market by the company after deducting the expected cost of selling the asset in the market. It is a crucial metric for determining the value of a company’s ending inventory or receivables.read more, etc.Initial Cost of acquisition – Amount paid for acquisition 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 simples to advanced examples to understand this concept in detail –

Example #1

Let us assume that Mr. X bought Apple Inc. shares 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.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 three tears, say on 01/01/2021, Mr. Y sold 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 three years, whereas Mr. X can get it within a year, which is more valuable than receiving it after three 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, a decision based on a just rate of return on investment can be futile. One must analyze every parameter before jumping to a conclusion.

Example #3

Mr. A bought a property in 2011 for $ 100,000, and in the year 2019, the said property was sold for $ 200,000.

Rate of return on investment in property calculation as = 200,000 – 100,000/100,000 * 100 = 100%

In the Manufacturing business case, Return on Investment = Revenue – Cost of goods sold divided by the cost of goods sold.

Example #4

Mr. B owns a company that is into the 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 soldCOGSThe 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:

= $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 two years, Mr. D decided to sell them at $ 150.

= ($150 – $100 / 100) * 100 = 50%.

Advantages

  • 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 investment like real estate, equity stock, preferred stock, etc.Expert knowledge is not required; even any layman can calculate what is in it for them.It helps in calculating returns in very little time and cost.Helps in making investment decisions like purchasing new assets vs. replacement of assets, 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.read more, diversification decisions, 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.read more decisions.

Disadvantages

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 it 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 the 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 layperson can derive the rate of return on investment and 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 and debt into consideration to derive at return), etc.

This article has guided the Rate of Return on Investment and its definition. Here we discuss components, formulas, 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 it from the following articles –

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