What is a Return?

A return is like the harvest from a fruit tree…

When you purchase a fruit tree, you’re making an initial investment in something that you hope will give you a good return in the form of a delicious fruit harvest. But growing a fruit tree takes a lot of time and effort. You have to plant and tend to the sapling and wait years for it to grow. If you take care of it and it is free from pests and severe weather, you’ll be rewarded with good harvests of fruit – similar to positive returns. However, if you don’t take care of the tree well or get unlucky, you might get a poor harvest or low-quality fruit – In this case, you get negative returns from the tree.

A return is the total amount of money that you make or lose from an investment over some period of time. The source of the return – whether from income earned on an investment (like the gains you may earn from a restaurant investment) or from changes in an asset’s value (like the price of a stock) – doesn’t matter. The only important number is the total amount of money you gain or lose from all sources related to your investment.

Returns can be positive or negative. Typically, investors report their returns as a nominal (aka unadjusted for inflation) amount – This gain or loss can be expressed in dollars or as a percentage of the initial amount invested. For example, someone who invests $1,000 upfront and gets $1,500 when they sell the investment has earned a total return of $500 ($1,500-$1,000) or 50% ((($1,500-$1,000)/$1,000)100).

A return can be expressed as either gross or net. A gross return doesn’t account for anything except the price change in the original investment over time. Meanwhile, a net return takes into account costs like taxes, fees, and commissions that investors may have to pay. For example, someone who makes money by buying and selling securities (e.g., stocks and bonds) may have to pay capital gains taxes or commissions on transactions.

Tracking a return is important for investors because it lets them compare the performance of similar investments against one another and analyze the success of theirs over a certain time period. It’s also important to look at multiple types of investments and compare the returns of each – Different assets and securities like stocks or bonds accomplish different goals in an investor’s portfolio. Often, higher risk investments may provide greater returns if they are successful, but greater losses if they are not. It is important to determine your level of risk tolerance when deciding which investments may be most suitable for your portfolio.

Investors can express a return in nominal (aka unadjusted) or real terms. A real return is adjusted for inflation and other external factors to provide a more accurate picture of the gain or loss in value.

A nominal return is the net change in the value of an investment over time, expressed as a profit or loss.

In addition to the straightforward change in an investment’s value, a nominal return also tends to factor in both distributions and outlays. Distributions add to the return of an investment – This may be dividends, rent, interest payments, or other cash flows. Outlays detract from a return and include things like taxes, commissions, and other fees that an investor may have to pay.

Importantly, a nominal return doesn’t account for the effects of inflation (aka the reduction in the purchasing power of a given currency over time) or other external factors. It simply reports the return as-is without any further adjustment.

For example, an investor who bought real estate for $250,000 in 2010 and sold it for $300,000 in 2020 has received a nominal return of $50,000 ($300,000-$250,000) or 20% ((($300,000-$250,000)/$250,000)100). However, inflation causes money to lose value over time due to the reduction in purchasing power. The $50,000 gain that the investor received in 2020 is worth less than if they had received that same $50,000 in 2010 – Therefore, the nominal return often overstates the gains that were made.

The benefit of calculating nominal return, however, is that it’s relatively simple and gives you a general idea of how well an investment is performing.

A real return adjusts the nominal return for the impact of inflation (aka the reduction in the purchasing power of a given currency over time).

Consider an investor who purchased real estate worth $200,000 in 2010 and sold it for $300,000 in 2020. The investor’s nominal return is the difference between the ending and starting value – This means that they nominally profited $100,000 ($300,000-$200,000) or 50% ((($300,000-$200,000)/$200,000)100).

However, over the course of that decade, the inflation rate in the US (as measured by the Consumer Price Index) was 16.9%. That means that the US dollar is 16.9% less valuable in 2020 than it was in 2010. The $300,000 that the investor received in 2020 is worth the equivalent of $249,270 ($300,000(1-.1691) = $249,270), as expressed in real terms adjusted for inflation.

That means the real return that the investor made in the real estate property was actually only $49,270 or 24.6% (((($249,270-$200,000)/$200,000)100).

For long-term investments, the real return is important because it provides a more realistic view of how much the investor gained or lost from an investment.

Return ratios are popular tools that investors use when analyzing the performance of their own investments and assessing the investment potential of businesses or other ventures. These ratios are most often expressed as percentages.

Return on investment (ROI) is a metric that is commonly used by investors to compare different opportunities and decide on the investments they’d like to make. Investors and businesses have limited resources, so they cannot invest in everything at once – They have to be choosy.

Once you’ve made an investment – whether that be in stocks, bonds, real estate, or a small business – ROI also tells you how well it is doing by comparing your profit to the amount of money you initially contributed. To calculate return on investment (ROI), you can use this formula: (Profit / Amount Invested) * 100 = Return on Investment (ROI)

For example, say a business generated $10M from an advertising campaign that cost them $500,000 to produce.

($10,000,000 / $500,000) * 100 = 2,000%

In this case, the company would have received an ROI of 2,000%. When comparing multiple investment opportunities, the one that offers a higher ROI is typically the better choice.

Return on equity (ROE) tells you how much profit a company is earning relative to the value of stockholders’ equity (the company’s total assets minus its total liabilities). That is, ROE compares a business’s net income to the equity of its shareholders. This metric tells you how well a company is generating profit for its owners.

The formula for ROE is as follows: (Net Income / Shareholders’ Equity) * 100 = Return on Equity (ROE) For example, say that a mid-sized software company has a net income of $50M and an average shareholder equity of $400M.

($50,000,000 / $400,000,000) = 12.5%

In this case, the return on equity would be 12.5%, which means that the software company was, on average, able to generate 12.5 cents of profit for every dollar of its shareholders’ ownership. To help understand if that’s good or bad, you could compare it to other mid-sized software companies, as well as this company’s ROE from prior years.

Investors use ROE to evaluate a company’s efficiency. The higher the percentage, the more effective the company is at turning its equity into profit – This helps indicate how well company leadership manages shareholders’ money.

Return on assets (ROA) is a measure of how effective a company is at using its assets to generate profits.

The formula for return on assets (ROA) is: (Net Income / Total Assets) * 100 = Return on Assets (ROA) For example, say that a restaurant makes $300,000 from selling food and carries an average of $1M worth of food and other assets, including cooking equipment.

($300,000 / $1,000,000) * 100 = 30%

In this case, the return on assets would be 30%.

Return on assets, like return on equity, is a measure of a company’s efficiency. How well can it turn its assets into profits? If a company increases its assets, can it increase its income at a similar level? When it comes to ROA, higher is better. A high ROA indicates that a company is doing a good job of making use of the assets it has at its disposal. Let’s consider the case where the above restaurant decides to expand to a second location. The company now makes $500,000, but has to double its assets to $2M to do so.

($500,000 / $2,000,000) * 100 = 25%

Its new return on assets is 25%, down from its ROA of 30% when it had just one location. The net income is higher, but the assets required to produce that income are also greater.

Investors typically get returns from the stock market in two ways: changes in share values and dividends.

When an investor purchases shares in a company, they become a partial owner of that business. That entitles them to many of the benefits of business ownership, such as the right to have a voice in how the business operates. It also gives them the right to some of the company’s profits if a business chooses to share them (which is at their discretion).

The most common way to share profits is through dividends, which are primarily cash payments. If a business chooses to pay dividends to shareholders, everyone who owns a share is entitled to receive a proportional cash payment from the company. The more shares someone owns, the larger their dividend payment. Dividends form part of the return an investor can earn from stocks.

Shares (aka stocks) also change in price regularly. If someone purchases a share in fictitious Widgets Central Inc. for $10, they might be able to sell that share for $11 the next week, $8 the week after that, and $15 a few months down the road. As stock prices change, shareholders gain or lose value, which impacts their investment returns.

To calculate the return on a stock, you compare the amount of value received to the amount that you spent upfront to purchase it.

You can use the following formula to find the nominal (aka unadjusted) return on a stock investment.

(Current Share Value + Dividends Received) - Price Paid = Nominal Return For example, if you bought ten shares in a company at $100 each, received $10 in dividends from each share, and and the shares are now worth $115, your nominal return is as follows:

(($115 x 10) + ($10 x 10)) - ($100 x 10) = $250

To find the inflation adjusted (aka real) return, you can use this formula:

((Current Share Value + Dividends Received ) * (1 - Inflation Rate Since Date of Purchase)) - Price Paid = Real Return

Assuming an inflation rate of 2% from the example above, the real return would be:

((($115 x 10) + ($10 x 10)) x (1 - .02)) - ($100 x 10) = $225

Determining an average rate of return on a stock depends on many factors. One of the most important things to consider is the risk involved. Higher risk investments typically must offer a better rate of return than lower risk investments to account for this increased uncertainty and potential for loss.

From 1928-2019, the S&P 500 Index (which measures the stock prices of the largest 500 companies in the US) has historically earned an average return of 7.67%, making this rate of return a solid target for most shares of large companies. Potentially riskier investments will often need to offer a better rate of return to investors to be worth the risk tradeoff.

This example of financial returns is an average over the course of 90 years. Some years saw much larger gains while others saw significant losses. Previous returns also do not guarantee that future returns will be similar, which makes due diligence important for anyone considering investing.