Rate of return (ROR) is the net gain or loss on an investment over a period of time. It has a lot of variations and applications. Besides investments, rate of return can apply to corporate profits, the return on a capital expenditure and others. In addition, there are a number of ways to calculate the rate of return beyond the basic calculation above.
The basic ROR formula above does not take time into account. It calculates the rate of return on an investment, company profits or other metrics from point A to point B. For example, a raw 20% return may or may not be a good thing. If that return is over a one-year period that might be very good. If the elapsed time is ten years, perhaps it is not so good.
Additionally, ROR needs to be compared to something. This could be your expectations for the return on this investment. In the case of a mutual fund or an ETF, the level of return is more relevant if compared to either other similar funds in this investment category or a market benchmark that is relevant such as the S&P 500 of the Russell 2000 index (for small cap stocks).
Variations of ROR
Here are some variations of ROR:
Total return
Total return is perhaps a more accurate measure of the return on an investment such as a stock, ETF, or mutual fund. Total return considers not only the price appreciation (or decline) on the investment, but also looks at distributions such as interest, dividends or capital gains distributions. In other words, it considers all forms of return on the investment.
Morningstar defines its calculation of total return like this: “Total return is determined by taking the change in price, reinvesting, if applicable, all income and capital gains distributions during the period, and dividing by the starting price.”
Internal Rate of Return (IRR)
Internal rate of return or IRR is often used when evaluating the return of a capital expenditure by a company. IRR looks at the cash flows from the investment over a period of time. These cashflows, both inflows and outflows, are projected over a period of time and then are discounted back to the present. The discount rate is akin to an interest rate and often equates to the company’s required rate of return on capital projects.
The IRR process takes the net cash flows projected from the expenditure and seeks to calculate a discount rate that brings the net present value of these inflows and outflows to zero. This can be an iterative process. The analyst may have to try several discount rates to find the one that brings the net present value to zero.
As an example, if the discount rate that ultimately brings the net present value of the proposed project’s cash flows to zero turns out to be 6.3% but the required return on a project such as the one the company is considering is 8% this may dissuade the company from moving forward, or it will likely at least force them to relook at all of the project assumptions, the level of the expenditure and other factors.
IRR can also be calculated at various points after the capital investment has been made to check to see if the return assumptions made prior to the commencement of the project have held up. IRR considers the time value of money, a very important concept.
Marginal rate of return
Marginal rate of return is often used by businesses to determine the additional level of revenue that would be generated by additional spending on the cost of producing additional levels of its product, or to provide additional levels of its service.
In order to calculate the marginal rate of return, you would need to estimate the additional revenue that would be derived from each additional unit of production. Then look at the additional cost the company would incur for each additional unit of production. The difference is the marginal return from each additional unit of production. Dividing this amount by the amount of revenue for each additional unit gives us the marginal rate of return.
Compound annual growth rate (CAGR)
Compound annual growth rate or CAGR represents the rate of growth that an investment would need to grow from its beginning value to an ending value over a set period of time. The use of CAGR allows an investor to calculate their rate of return over a given period of time on an annualized basis. This version of ROR allows an investor to evaluate their return on investment over a period of years
The formula for CAGR is:
Divide the ending value of the investment by the beginning value of the investment for a certain time period.
Raise the value calculated in the first step by an exponent of 1 divided by the number of years you are calculating the CAGR for.
Subtract 1 from this result.
For example: The CGAR over a five-year period for a portfolio with a beginning value $100,00 and an ending value of $155,000 is 9.16%. (An online calculator can be used to do the calculation.)
How to calculate the rate of return
The rate of return is calculated as follows:
(the investment’s current value – its initial value) divided by the initial value; all times 100. Multiplying the outcome helps to express the outcome of the formula as a percentage. Let’s look at an example.
Current value of the investment = $50,000
Initial value (or cost basis) of the investment = $40,000
Using the formula above, the ROR on this particular investment would be 25%.
What is a good rate of return?
It depends. A good or acceptable rate of return can vary. Here are some examples.
In looking at an investment such as a mutual fund or ETF, the answer to what constitutes a good rate of return might be one that is in the upper half or even the top quarter of the average return for funds in the same investment category. Morningstar has a number of categories for ETFs and mutual funds that invest in stocks of various types, as well as in bonds.
In looking at a diversified investment portfolio, the investor might have an annual target rate of return that they are trying to achieve in order to reach a goal like saving for their retirement or their children’s college education within a certain period of time. They might benchmark their annual return against that goal on an annual basis.
In the case of internal rate of return for the review of capital expenditures for a company, they might have a hurdle rate of return which is the level of IRR that a project must exceed in order to be approved for a capital expenditure by the company.
Limitations of ROR
Like any measurement, rate of return can provide good information, but also has its limitations.
Historical rates of return are just that:" historical. Rate of return measures past performance. It is not an indicator of what might happen in the future.
Rate of return needs to be looked at in the context of something. Maybe it is in comparison to the investor’s own personal return goals. Maybe it is in line with their desired progress towards a goal like retirement. Or perhaps the comparison is to other investments of a similar type. For example, in the case of a mutual fund or an ETF this might be in comparison to other funds or ETFs in the same Morningstar category.
Rates of return should be calculated over the same period of time if looking to compare the rate of return for two or more different investments.
When using rate of return as a way to look at the potential of a prospective investment, the assumptions as to potential future returns must be scrutinized carefully to ensure they represent a plausible and realistic look at what the future might hold for the investment being considered. Manipulating assumptions can be a way for those selling investments to make them look more attractive to potential investors than they otherwise might be. In the case of capital budgeting within a company, the same can hold true as different departments compete for scarce resources.
When using a tool like internal rate of return, it is important to be careful not to look out too far into the future and assume the discount rate calculated will hold true for 20, 30 or more years. Circumstances change and likely so will interest rates and the cost of capital and other factors impacting the discount rate.
