What is Rate of Return (RoR)?

Rate of return is like determining if college is worth it…

When you decide to go to college, you are investing a great deal of time and money in yourself. You give up the wages you could earn right out of high school, plus hefty fees for tuition, books, etc. — all for the expectation that you will make a better wage with that degree in hand. Similarly, when you make an investment, you give up access to your capital for a while, and hope that the rate of return makes it worthwhile.

An investment’s rate of return (RoR) tells you how hard your money is working for you. It’s a measure of your earnings compared to how much money it costs you to participate. You can calculate the RoR on any investment — Whether it is stocks, bonds, real estate, or baseball cards.

By calculating the RoR on several investment opportunities, you can directly compare them to decide which are performing well and which are not. Using this comparison, you can decide which investments to pursue more aggressively and which ones to sell.

However, RoR is just one of many measures and only gives you insight from one perspective. So, it might not tell you exactly how to proceed. RoR does not account for the time value of money or the risk associated with the investment. It is a simple measure of value that only provides a glimpse at the historic performance of your investment.

To calculate a rate of return (RoR), you simply divide the total return from an investment by the cost of the initial investment. The result is a percentage value that tells you how well your investment has performed since you purchased it. There are two components of earnings that must be accounted for — capital gains and cash flow.

Capital gains refer to the change in the value of an asset. For most investments, this is simply the sales price minus the purchase price. Cash flows are the money that you receive from the investment while you hold it. For a bond, this includes the coupon rate. For a stock, it would be any dividends that were paid. For real estate, it would be any lease payments or rent you collect.

The rate of return formula is:

RoR = ((sales price – purchase price) + cash flows) / purchase price

The nominal rate of return is simply the total gains divided by the purchase price of the asset. It does not adjust the time value of money or the effects of inflation (the tendency for all prices to rise over time).

It is possible that your investment grew with inflation, but didn’t earn you any real money. If your $1,000 investment grew to $1,100 while you held it, but the cost of everything increased by 10% over the same period, your investment can only get you the same things you already could have bought — Your purchasing power hasn’t changed at all.

To understand how much better off you are, you need to account for how much of the earnings came from inflation. The easiest way to do this is to inflate the purchase price of your asset into current dollars. To do so, divide the current consumer price index (CPI) by the purchase year CPI. Then multiply that ratio by the purchase price.

Subtracting the real purchase price from the final value of an investment will tell you how much more than inflation the asset grew.

Real purchase price = Current year CPI / Purchase year CPI x purchase price

Real RoR = ((sales price – real purchase price) + cash flows) / real purchase price

If you have already solved for the nominal rate of return, you can simplify this equation a little bit. The real rate of return calculation is based on the RoR and inflation percentages.

Rate of Return (RoR) and return on investment (ROI) are very similar terms, usually calculated in very similar ways.

In common use, RoR is more likely to refer to an annual rate of return. ROI is more likely to be used to describe the return over the full life of the investment.

In using either term, it is best to specify exactly how you are using it.

The rate of return (RoR) of an investment is a simple measure of how much an asset earns for you. But, it does not account for the time value of money. That’s where the internal rate of return (IRR) comes in.

The IRR discounts cash flow payments into a common year’s value, which allows a better comparison of how much income was created over time. That can be important if you are trying to compare investment opportunities.

For example, imagine two investments that each require $1,000. One of them will pay you $1,100 next year. The other will pay you $1,100 two years from now. Both of these investments have the same 10% RoR, but they are not equal.

Receiving the payment a year earlier allows you to redeploy the principal into another investment a year earlier. It also allows you to increase your investment by $100 for the second year. This is the time value of money at work and the IRR exposes the difference.

Calculating the IRR is easiest in Excel or with a financial calculator. The idea is to convert the cash flows into a net present value (NPV, which is the amount you would need to invest today, at the given interest rate, to achieve the future payment).

The IRR is the discount rate at which the NPV of the future payment is equal to the cost of the investment today. In Excel, there is an IRR function that makes the calculation very easy.

Most companies have a limited amount of capital that they can dedicate to new projects. Often, the capital must be raised by issuing debt, which requires the payment of interest. If a company cannot expect to make a good enough return from the project to cover the weighted average cost of capital, the project is not worth pursuing.

Therefore, projects usually have to demonstrate that they will produce an internal rate of return higher than some required amount (such as the interest rate on its debt) before the project will be considered by the board of directors. This investment threshold is known as the required rate of return or is sometimes called the company’s hurdle rate.

Rate of return (RoR) usually doesn’t account for the amount of time that an investment is held. So, it can be a little misleading when you have an asset you have owned for a long time.

For example, imagine that you owned a house for 10 years. You paid $200,000 for that real estate and then you sell it for $250,000 a decade later. The simple RoR on that investment is 25% ($50,000 / $200,000). But that might be misleading if you compare it to an 8% return you got on your stocks last year. The holding period was much longer for the house. Therefore, it’s not clear that you made a better return on real estate than equities.

It would make more sense to normalize the holding periods to the same amount of time. From there you can make the comparison more fairly. An annualized rate of return is one way to normalize those earnings.

The simplest form of computing an annual return is to divide the RoR by the number of years the asset was held ⁠— Including decimals for partial years. That will give you the simple arithmetic mean annual rate of return.

A more technically correct measure of the average annual return is to account for the compounding effect of an investment’s growth over a given time, which is what CAGR does.

A compound annual growth rate (CAGR) is a more sophisticated way to look at how well an investment has performed. While the simple rate of return (RoR) does not account for how long an asset was owned, the CAGR does.

And, rather than computing a simple annual average return, the CAGR formula accounts for the compounding interest that results as the investment value grows over time.

The formula for calculating the CAGR is:

CAGR = ((Sale price / purchase price) ^ (1 / years)) - 1

Return on equity (ROE) has a special meaning that is slightly different than it sounds. While the rate of return (ROR) is a measure of an investment’s performance, ROE is a measure of a company’s strength relative to its net assets.

To compute ROE, you simply divide a company's net income by its shareholder equity. This tells you how much earnings a company is generating from its net assets.

A good rate of return (RoR) is in the eye of the beholder. But, generally speaking, a good rate of return is one that beats the next best alternative. Of course, you also need to account for the amount of risk that is assumed when you invest. The RoR can’t be considered good or bad without considering those other factors.

Depending on your tolerance for risk, earning a 5% risk-free RoR might be better than buying a bond from a high-risk company that might go bankrupt before paying you. Even though the bond yield is a higher RoR, that’s not necessarily a good rate of return once you consider the risk.