Rate of Return (RoR) Meaning, Formula, and Examples (2024)

What Is a Rate of Return (RoR)?

A rate of return (RoR) is the net gain or loss of an investment over a specified time period, expressed as a percentage of the investment’s initial cost. When calculating the rate of return, you are determining the percentage change from the beginning of the period until the end.

Key Takeaways

  • The rate of return (RoR) is used to measure the profit or loss of an investment over time.
  • The metric of RoR can be used on a variety of assets, from stocks to bonds, real estate, and art.
  • The effects of inflation are not taken into consideration in the simple rate of return calculation but are in the real rate of return calculation.
  • The internal rate of return (IRR) takes into consideration the time value of money.

Rate of Return (RoR) Meaning, Formula, and Examples (1)

Understanding a Rate of Return (RoR)

A rate of return (RoR) can be applied to any investment vehicle, from real estate to bonds, stocks, and fine art. The RoR works with any asset provided the asset is purchased at one point in time and produces cash flow at some point in the future. Investments are assessed based, in part, on past rates of return, which can be compared against assets of the same type to determine which investments are the most attractive. Many investors like to pick a required rate of return before making an investment choice.

The Formula for RoR

The formula to calculate the rate of return (RoR) is:

Rateofreturn=[(CurrentvalueInitialvalue)Initialvalue]×100\text{Rate of return} = [\frac{(\text{Current value} - \text{Initial value})}{\text{Initial value}}]\times 100Rateofreturn=[Initialvalue(CurrentvalueInitialvalue)]×100

This simple rate of return is sometimes called the basic growth rate, or alternatively, return on investment (ROI). If you also consider the effect of the time value of money and inflation, the real rate of return can also be defined as the net amount of discounted cash flows (DCF) received on an investment after adjusting for inflation.

RoR on Stocks and Bonds

The rate of return calculations for stocks and bonds is slightly different. Assume an investor buys a stock for $60 a share, owns the stock for five years, and earns a total amount of $10 in dividends. If the investor sells the stock for $80, their per-share gain is $80 - $60 = $20. In addition, they have earned $10 in dividend income for a total gain of $20 + $10 = $30. The rate of return for the stock is thus a $30 gain per share, divided by the $60 cost per share, or 50%.

On the other hand, consider an investor that pays $1,000 for a $1,000 par value 5% coupon bond. The investment earns $50 in interest income per year. If the investor sells the bond for $1,100 in premium value and earns $100 in total interest, the investor’s rate of return is the $100 gain on the sale, plus $100 interest income divided by the $1,000 initial cost, or 20%.

Real Rate of Return vs. Nominal Rate of Return

The simple rate of return is considered anominal rateof return since it does not account for the effect of inflation over time. Inflation reduces the purchasing power of money, and so $335,000 six years from now is not the same as $335,000 today.

Discounting is one way to account for the time value of money. Once the effect of inflation is taken into account, we call that the real rate of return(or the inflation-adjusted rate of return).

Real Rate of Return vs. Compound Annual Growth Rate (CAGR)

A closely related concept to the simple rate of return is the compound annual growth rate (CAGR). The CAGR is the mean annual rate of return of an investment over a specified period of time longer than one year, which means the calculation must factor in growth over multiple periods.

To calculate compound annual growth rate, we divide the value of an investment at the end of the period in question by its value at the beginning of that period; raise the result to the power of one divided by the number of holding periods, such as years; and subtract one from the subsequent result.

Example of RoR

The rate of return can be calculated for any investment, dealing with any kind of asset. Let's take the example of purchasing a home as a basic example for understanding how to calculate the RoR. Say that you buy a house for $250,000 (for simplicity let's assume you pay 100% cash).

Six years later, you decide to sell the house—maybe your family is growing and you need to move into a larger place. You are able to sell the house for $335,000, after deducting any realtor's fees and taxes. The simple rate of return on the purchase and sale of the house is as follows:

(335,000250,000)250,000×100=34%\frac{(335,000-250,000)}{250,000} \times 100 = 34\%250,000(335,000250,000)×100=34%

Now, what if, instead, you sold the house for less than you paid for it—say, for $187,500? The same equation can be used to calculate your loss, or the negative rate of return, on the transaction:

(187,500250,000)250,000×100=25%\frac{(187,500 - 250,000)}{250,000} \times 100 = -25\%250,000(187,500250,000)×100=25%

Internal Rate of Return (IRR) and Discounted Cash Flow (DCF)

The next step in understanding RoR over time is to account for the time value of money (TVM), which the CAGR ignores. Discounted cash flows take the earnings of an investment and discount each of the cash flows based on a discount rate. The discount rate represents a minimum rate of return acceptable to the investor, or an assumed rate of inflation. In addition to investors, businesses use discounted cash flows to assess the profitability of their investments.

Assume, for example, a company is considering the purchase of a new piece of equipment for $10,000, and the firm uses a discount rate of 5%. After a $10,000 cash outflow, the equipment is used in the operations of the business and increases cash inflows by $2,000 a year for five years. The business applies present value table factors to the $10,000 outflow and to the $2,000 inflow each year for five years.

The $2,000 inflow in year five would be discounted using the discount rate at 5% for five years. If the sum of all the adjusted cash inflows and outflows is greater than zero, the investment is profitable. A positive net cash inflow also means that the rate of return is higher than the 5% discount rate.

The rate of return using discounted cash flows is also known as the internal rate of return (IRR). The internal rate of return is a discount ratethat makes the net present value (NPV) of all cash flows from a particular project or investment equal to zero. IRR calculations rely on the same formula as NPV does and utilizes the time value of money (using interest rates). The formula for IRR is as follows:

IRR=NPV=t=1TCt(1+r)tC0=0where:T=totalnumberoftimeperiodst=timeperiodCt=netcashinflow-outflowsduringasingleperiodtC0=baselinecashinflow-outflowsr=discountrate\begin{aligned} &IRR = NPV = \sum_{t = 1}^T \frac{C_t}{(1+ r)^t} - C_0 = 0 \\ &\textbf{where:}\\ &T=\text{total number of time periods}\\ &t = \text{time period}\\ &C_t = \text{net cash inflow-outflows during a single period }t \\ &C_0 = \text{baseline cash inflow-outflows}\\ &r = \text{discount rate}\\ \end{aligned}IRR=NPV=t=1T(1+r)tCtC0=0where:T=totalnumberoftimeperiodst=timeperiodCt=netcashinflow-outflowsduringasingleperiodtC0=baselinecashinflow-outflowsr=discountrate

What Are Some Alternatives to the Rate of Return?

The Internal Rate of Return (IRR) and the Compound Annual Growth Rate (CAGR) are good alternatives to RoR. IRR is the discount rate that makes the net present value of all cash flows equal to zero. CAGR refers to the annual growth rate of an investment taking into account the effect of compound interest.

What Are Some Drawbacks of RoR?

The rate of return disregards some key factors in an investment, like the time value of money, the timing and size of cash flows, and the risk and uncertainty associated with any investment.

What Is Considered a Good Return on an Investment?

A good return on investment is generally considered to be about 7% per year, which is also the average annual return of the S&P 500, adjusting for inflation.

The Bottom Line

The rate of return (ROR) is a simple to calculate metric that shows the net gain or loss of an investment or project over a set period of time. RoR is expressed as a percentage of the initial value.

The internal rate of return (IRR) also measures the performance of investments or projects, but while ROR shows the total growth since the start of the project, IRR shows the annual growth rate. The Compound Annual Growth Rate (CAGR) is another metric that shows the annual growth rate of an investment, but this time taking into account the effect of compound interest.

Rate of Return (RoR) Meaning, Formula, and Examples (2024)

FAQs

What is the RoR formula example? ›

The formula for calculating rate of return is R = [(Ve Vb) / Vb] x 100, where Ve is the end of period value and Vb is the beginning of period value. Rate of return calculations should be consistent in terms of the holding period to accurately compare investment performance.

What is the general formula for RoR? ›

In organic chemistry, ethers are a class of compounds that contain an ether group—an oxygen atom connected to two organyl groups (e.g., alkyl or aryl). They have the general formula R−O−R′, where R and R′ represent organyl groups (e.g., alkyl or aryl).

What is rate of return with example? ›

The annual rate of return is the percentage change in the value of an investment. For example: If you assume you earn a 10% annual rate of return, then you are assuming that the value of your investment will increase by 10% every year.

What does RoR mean rate of return? ›

A rate of return (RoR) is the net gain or loss of an investment over a specified time period, expressed as a percentage of the investment's initial cost. When calculating the rate of return, you are determining the percentage change from the beginning of the period until the end.

What is the ROR rate of return and how do you calculate it? ›

How do you calculate the rate of return? The rate of return is simply the percentage change in value over a period of time. It's calculated by subtracting the initial investment from its final value, then dividing that number by the initial amount invested. It's then multiplied by 100 to get a percentage.

What is the simple rate of return? ›

The simple rate of return method measures how much a company expects to profit from a capital investment each year. The formula for simple rate of return is the increase in accounting net income from an investment divided by the cost of the investment.

What is the RoR in accounting? ›

A Rate of Return (ROR) is the gain or loss of an investment over a certain period of time. In other words, the rate of return is the gain (or loss) compared to the cost of an initial investment, typically expressed in the form of a percentage.

What is the common name of RoR? ›

Ethers can be defined as a class or a group of organic compounds comprising an oxygen atom, which is bonded to two same or different alkyl or aryl groups. The general formula for ethers is R-O-R, where R represents an alkyl group.

What is the formula of rate? ›

Using the simple interest formula, SI = PRT/100. To find the rate R from this, we just solve this equation for R. Then we get R = (SI × 100) / (P × T).

What is the difference between ROR and interest? ›

The rate-of-return condition says just that all assets share a common expected rate of return. The “market interest rate” refers to the expected rate of return common to all assets. We assume that the market interest rate R > 0 is constant.

What is the rate of return on a security that costs $1000 and returns $2000 after 5 years? ›

Answer and Explanation:

The calculated value of the rate of return is 14.87%.

What is a good rate of return? ›

General ROI: A positive ROI is generally considered good, with a normal ROI of 5-7% often seen as a reasonable expectation. However, a strong general ROI is something greater than 10%. Return on Stocks: On average, a ROI of 7% after inflation is often considered good, based on the historical returns of the market.

What is the most common rate of return? ›

While 10% might be the average, the returns in any given year are far from average. In fact, between 1926 and 2022, returns were in that “average” band of 8% to 12% only seven times. The rest of the time they were much lower or, usually, much higher. Volatility is the state of play in the stock market.

Top Articles
Latest Posts
Article information

Author: Duncan Muller

Last Updated:

Views: 5851

Rating: 4.9 / 5 (59 voted)

Reviews: 90% of readers found this page helpful

Author information

Name: Duncan Muller

Birthday: 1997-01-13

Address: Apt. 505 914 Phillip Crossroad, O'Konborough, NV 62411

Phone: +8555305800947

Job: Construction Agent

Hobby: Shopping, Table tennis, Snowboarding, Rafting, Motor sports, Homebrewing, Taxidermy

Introduction: My name is Duncan Muller, I am a enchanting, good, gentle, modern, tasty, nice, elegant person who loves writing and wants to share my knowledge and understanding with you.