Must-Know Knowledge About The Simple Rate of Return

Is the risk you take on an investment worth the expected returns? Knowing how to calculate the simple rate of return and the factors affecting the rate can help you make an optimal investment.

A simple rate of return is the percentage gained or lost on an initial investment for a certain period of time. When the ROR is positive, it reflects the gain. In contrast, if the ROR is negative, it is considered a loss on the investment.

The Formula For Calculating The Simple Rate Of Return (ROR)

The formula for calculating ROR as follows:

Rate of return =Ending value of investment – Beginning value of investment Beginning value of investment   x 100

Sometimes, this ROR, also called the basic growth rate, reflects the percentage change of an investment value for a particular period of time.

Notably, during the holding period of investment, any gains are included in this above formula. It turns out to be:

Rate of return =Ending value + any gains during the holding period (if any) – Beginning valueBeginning value of investment x 100

An Example For ROR

Eva is an investor and decides to purchase 20 shares of Company X at a unit price of $30. Eva holds on Company X’s shares for three years. During that time, Eva receives an annual dividend of $1 per share. After holding for three years, Eva decides to sell 20 Company X’s shares at a unit price of $40.

How to define the ROR? Let’s follow some steps:

Firstly, we calculate the total costs Eva paid for buying 20 Company X’s shares:

20 shares * $30 = $600

Then, we find the total dividends yielded on Eva’s shares over three years:

20 shares * 1$ yearly dividend * 3 = $60

Then, calculate how much she gained from selling 20 shares:

20 shares * $40 = $800

Lastly, plug all numbers into the ROR formula to figure out:

ROR = ($800 + $60) – $600$600 x 100 = 43,33%

In brief, Eva had a 43.33% return on her shares during the three-year holding period.

Factors Affect                                        

Before making investment decisions, you should consider many factors influencing the rate of return.

Investment portfolio

Various return rates from different investments can average your overall return. When you invest, you’re exposed to different types of risks. Keep in mind the quote :  “Don’t put all your eggs in one basket”. The more diversified your investment portfolio is, the less volatilite your return is.

Government and political factors

Indeed, fiscal policies or political stability can affect the rate of return. Large fiscal deficits may result in government’s competition for capital, leading to higher overall borrowing costs for businesses. Hence, it may reduce the potential rate of return. Meanwhile, political instability leads to uncontrolled investment return’s fluctuation.

Company competitive advantages

Usually, the comparable and differential advantages come from efficient cost control, distinct branding, better quality of product’s offerings, smart distribution network, making companies’ products or services more desirable to customers. As a result, companies can generate more sales or profit margins than their rivals over a long-term time frame. 

The macroeconomic conditions

Note  that the general economy also affects the rate of return on investment. An economy with a high growth rate will push up consumer demand. Therefore, the businesses can earn more sales or profits. However, rapid economic growth can result in higher interest rates. In the long run, credits become more expensive, slowing down consumer spending and lowering businesses’ revenues.

The Real Rate Of Return

The real rate of return is the return earned above the effect of inflation. It can reflect the actual profit or loss gained on an investment, adjusted for inflation. 

Must-Know Knowledge About The Simple Rate of Return

The real ROR is the return earned above the effect of inflatio. Source: Finology blog

The Formula For Calculating The Real ROR

We have the formula for the real rate of return:

The real rate of return = the simple rate of return – Inflation rate

An Example Of The Real ROR

For instance, if you have a 10% return on your $10,000 investment in one year, you would end the year with $11,000 in total. However, if the inflation rate is 5% for the year, your return is 5%.

If the simple rate of return is only equal to the inflation rate, it will be an unprofitable investment. The initial investment falls into “idle status.” Obviously, the investors want a real rate of return that can exceed the inflation. As such, the final investment returns can compensate for the inflation rate.

Other Factors Affect The Real ROR

Unfortunately, an inflation rate is considered a “trailing indicator” that can be only defined after the specific period has ended. Hence, you only know what the real rate of return is until it has actually happened. What’s more, the real rate of return can’t be calculated accurately unless it accounts for taxes and other fees (i.e investing fees).

A Fair ROR

The fair rate of return is the return that state governments allow companies to earn on their investments. In this case, “fair” can be understood as “just”. In fact, governments impose a fair ROR on “natural monopoly” industries (i.e, gas, electricity, and water) as they want to keep affordable services or goods for public functions available for customers. 

How To Define The Fair ROR

For managers, a fair rate of return is a decent profit for their organizations. In other words, it is a reasonable profit based on operating expenses and shareholders’ obligations. Hence, regulators define this rate to assure that these organizations can generate stable returns to make services accessible to customers and compensate for their stockholders.

Factors Affect The Fair ROR

Typically, regulators base their calculations on businesses’ operating expenses (i.e facilities maintenance, payroll and investment in business’s activities) and expected shareholder’s benefits. Electric companies, for instance, may need to expand their capacity to serve customers and invest in more innovative control systems to upgrade their services. The governments can calculate a fair rate of return for these companies which may tend to be lower than the rest of the market . However, they can have stable investments to offer affordable goods and services for the general public. 

Conclusion

When it comes to an investment, the simple rate of return is the key factor significantly affecting your decisions. You should carefully consider many factors such as economic conditions and businesses’ strategies to find the optimal investment.

Grasp Your Attention:

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Essentials About Current Maturities of Long-term Debt

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