Rate of Return on Investment

The rate of Return on Investment refers to the rate with which the company generates a return from the investment during a period compared with the cost of the investment made by the company. The rate of return on investment calculator is used by dividing the return on investment during the period by the investment cost.

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. 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.

• The rate of return on investment measures the percentage of profit a company earns from an investment compared to its cost. This is calculated by dividing the investment's return during a specific period by the investment cost.
• The rate of return on investment may not be reliable for periods longer than a year because it doesn't consider the time value of money.
• As a useful tool, the rate of return on investment helps in making sound investment decisions, such as choosing between new purchases or replacements, expanding fixed assets, diversifying portfolios, and making mutually exclusive choices.

The rate of return on investment is the percentage in which the company or an individual investor experiences gains or losses for the amount invested within a financial year or any assessment period curated by them or regulatory authorities.

The rate is generally calculated in terms of percentages as it gives a clear picture of the growth of within the period of assessment.

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 money. 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 investments), return on investment, return on capital employed (it takes equity and debt into consideration to derive at return), etc.

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.

Let us understand the formula to calculate both the average rate of return on investment and the overall growth of the assessing entity by first understanding the formula for calculation.

They can be measured in different terms like return on capital employed, return on equity, 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

(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 value, 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)

Let us understand how to use the rate of return on investment calculator with the help of a few examples.

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 loss.

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 sold 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%.

Calculating the average rate of return on investment can reveal a lot about the financial health of the organization or individual and their decision-making in this facet of life. Let us understand the advantages of keeping a close eye on this metric.

• 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 asset, diversification decisions, mutually exclusive decisions.

Despite the advantages mentioned above, there are factors from the other end of the spectrum that prove to be hassles or hurdles for users. Let us understand the disadvantages of using the rate of return on investment calculator through the brief discussion below.

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.

This article has been a guide to what is Rate of Return on Investment. Here we explain its formula, and calculation with examples, advantages, and disadvantages. Here we also discuss the advantages and disadvantages. You can learn more about it from the following articles –

• Veblen Goods
• CFROI
• Calculate Return on Investment