Rate of Return

November 23, 2010Investing

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Rate of return (ROR), or the rate of profit (ROP), is a crucial measure of how lucrative an investment is. It indicates whether an investment is viable or not and how efficient it is. The rate of return is also known as the return on investment (ROI) and is a ratio of the amount of money gained or lost to the amount of money that is invested.

Rate of Return: Calculation

The rate of return is always expressed as a percentage and is calculated using the following formula:

ROR = (Net Income / Investment Cost) x 100

where

Net Income = Gain on Investment - Investment Cost

For instance, if the investment cost is \$40,000 and the gain is \$42,000, then the net income is \$42,000 - \$40,000, or \$2,000. This gives an ROR of (\$2,000/\$40,000) x 100, which is equal to 0.05 x 100, or 5%. A higher ROR indicates better returns.A negative ROR indicates losses.

The rate of return is indicative of only the profitability and not the size or duration of an investment. ROR also does not take into account inflation. However, the two should be compared. If the rate of return is lower than the annualinflation rate, there will be erosion in value.

The Importance of Rate of Return

The rate of return is a concept used for various purposes, such as:

• Since ROR is a measure of the profitability of any form of investment, including real estate, treasury bills, stocks, foreign exchange and even antiquities, it is used by varied investors. Financial instruments are usually ranked on the basis of their previous rates of return, which help an investor make crucial financial decisions.
• Companies prefer those projects that generate the maximum wealth for stockholders. Hence, companies compare RORs while finalizing projects.
• Financial analysts compare the rate of return between companies to determine which stock promises a higher yield.

Annual ROR and Annualized ROR

An annual rate of return refers to a single-period return. For instance, an annual rate of return of 10% indicates that the return on an investment is 10% over the period of a year. On the other hand, an annualized rate of return is a multi-periodaverage return. For instance, if the ROR is 1% for one month, the annualized rate of return will be 12%.