Rate of return communicates how efficiently an investment is performing. It is expressed as a percentage of how much the investment’s value has changed compared to its original cost. The higher the ROR, the better the investment. Investors and analysts also use ROR to compare the attractiveness of different investments.
The definition of ROR is change in value divided by original value. The numerator is the current value minus the original investment, and the denominator is the original investment. All costs are included in the original investment amount, including commissions, fees and taxes. Once the quotient is calculated, multiply it by 100 to convert it to a percentage.
On April 1, you purchase 100 shares of XYZ Corp for $40/share, or $4,000. Transaction costs add another $6, for a total original investment cost of $4,006. At the end of trading on June 30, the price of XYZ is $47, making the current investment value $4,700. ROR in decimal form is (($4,700 - $4,006) / $4,006), or 0.1732. Multiply by 100 to convert it to 17.32 percent. The investment achieved this result in 91 days.
One way to compare investments is to compute RORs for the exact same period. In the example, this was April 1 through June 30. Sometimes this isn’t feasible, but by annualizing ROR, you can compare investments on an equal basis regardless of holding period. To calculate annualized ROR for the example investment, start by adding 1 to the decimal ROR, giving you 1.1732. Raise this value by an exponent of 365 days divided by the investment period and then subtract 1 from the result. In this case, the annualized ROR is ((1.1732 ^ (365/91) – 1), which is 0.8978, or 89.78 percent. This isn’t a guarantee that you will earn this return if you hold the investment for a year. It merely puts different investments on an equal time basis.
While ROR is a useful tool to compare how efficiently your investment is performing, it does not give you any idea about the riskiness of the investment. You can factor in risk with several ratios, such as the Sharpe ratio. This ratio subtracts the risk-free rate (usually the short-term interest rate on U.S. Treasury debt) from the ROR and divides it by standard deviation for the period, which is a measure of the investment’s riskiness. Assuming standard deviation for XYZ stock for the investment period was 8 percent, and the average risk-free rate was 2 percent, the Sharpe ratio is (17.32% -2%) / 8%, or 1.915. You can compare this with the Sharpe ratio of other investments, bearing in mind that the higher the Sharpe ratio, the better the investment on a risk-adjusted basis.
- Return on investment is figured pretty much the same way for all investments. However, the details vary. For instance, the total investment for a business is the business’s net worth plus its total debt. The return in dollars is the after-tax profit the business earned.
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