Calculating the Return Rate on Investments

A return rate is the measurement of increase or decrease over a specific time period. You invest to earn a return in the form of income (interest plus dividends) and / or increase capital (when a sold investment price is higher than that paid for.) Some investments such as savings accounts and deposit certificates offer only incomes but no increase in capital. Others such as common stocks offer a potential capital increase and may or may not pay dividends.  If the price of an stock decreases below the buying price and you sell said stock you have a capital loss. A simple definition of the total return includes the income and the capital earned or lost. To calculate returns is important because it measures the growth or decline of your investment and provides a measure to assess portfolio performance in relation to your objectives.

You may calculate the total return rate in the following way:    

     ( Last value – Initial value) + Income

Return rate for maturity period =   Gross Buying Price

You should include increase of capital and commissions in your estimates. For example, if you have bought stock at the beginning of the year for $1500 (including commissions) and sold at the end of the year for $1800 (net product received after deducting commissions) and you earn a $50 dividend the return rate would be 23%

   (1800 – 1500) + 50 = 23%

Return rate =     1500

This return rate is simple and easy to use, but it is quite inexact if the investment is kept for a long period because time is money and is not taken into account.

The value of time over money is a concept that recognizes that today’s dollar, has a higher value than in the future because its potential profits are bigger. For example, if you invest a dollar at 5% per year it would be worth $1.05 at the end of the same.
Equally, if you receive a dollar at the end of the year it would be worth less than if you had received it at the beginning of that same year. This simple average return rate of 23% doesn’t include or consider the interests capacity to earn profits. In other words, if you had to re-invest those $50 of received interests the return rate would increase more than 23%.

Using the time value over money to calculate the return rate can be more exact. However, it is more difficult to calculate because a stock’s return rate equals the cash flow discounted from future dividends, and that from the expected sales price per stock in relation to the buying price.  This formula works out better with bonds than with common stocks because the coupon rate for bonds are generally fixed. Therefore rates over dividends in common stocks fluctuate (that is why you can only speculate). When companies experience losses they could reduce the dividend payments exactly as Ford Motor Company did to preserve its money in cash.  If a company’s earnings increase, the company can also increase the amount paid for dividends. The future sales price of a stock is even less certain. Bonds are retired from its parity price upon maturity ($1000 per bond). But when a stock is eventually sold no one knows what its future sales price will be.