What it means
The measure exists to make comparison possible. Making $4,500 tells you nothing until you know whether it took $25,000 or $250,000 to earn it, and expressing the result as a percentage removes the effect of scale.
A complete rate of return includes both parts of the gain: the change in the value of the asset and any income received along the way, such as dividends, interest or rent. Leaving out the income is one of the most common ways of understating a return.
Time matters just as much as the amount. A 18% return earned in one year and the same 18% earned over three years are very different outcomes, which is why returns covering more than a year are usually annualised so they can be compared fairly.
Businesses use the same idea inside their own operations under names like return on investment, return on capital employed and internal rate of return. Each applies the logic of gain over outlay to a project, a division or the company as a whole.
The nuance most often missed is risk. A higher rate of return is only better if the risk taken to earn it is comparable, and comparing a government bond yield with a start-up equity return as though they were interchangeable is a mistake.
In practice
Real-world examples.
Example
A property investor buys a small retail unit for $420,000, receives $63,000 of net rent over two years and sells for $448,000. The total return is ($448,000 - $420,000 + $63,000) / $420,000, or about 21.7% across the two years.
Example
A manufacturer spends $85,000 on an automated packing line that saves $34,000 of labour cost a year. The simple annual rate of return on the outlay is roughly 40%, which is why the finance director approves it ahead of three competing projects.
Example
A treasury team compares a 12-month deposit paying 4.5% with a short-dated bond fund that returned 6.1% last year. It chooses the deposit because the bond fund's return is not guaranteed and the cash is needed for a scheduled tax payment.
Formula
Calculation
Rate of Return = (Ending Value - Beginning Value + Income Received) / Beginning Value x 100
Annualised Rate of Return = ((Ending Value + Income) / Beginning Value) raised to the power of (1 / Number of Years), minus 1
An investor buys a parcel of shares for $25,000 and holds them for three years, receiving $1,000 in dividends in total, then sells the parcel for $28,500.
Gain = $28,500 - $25,000 + $1,000 = $4,500
Rate of Return = $4,500 / $25,000 = 0.18, which is 18%
That 18% is the total return across the whole three years, not per year. To annualise it, the total value returned is $28,500 + $1,000 = $29,500, so the growth factor is $29,500 / $25,000 = 1.18. Taking the cube root of 1.18 gives about 1.0567, so the annualised rate of return is roughly 5.7% a year.
If the same $4,500 gain had been earned in a single year, the return would have been 18% for that year, which is a far better outcome for the same dollars.Case study
Seen in the real world.
Vaneck Joinery is a fictional cabinet maker used here for an illustrative case study. Its owner was choosing between two uses for $180,000 of surplus cash: a new computer-controlled router or a second delivery vehicle and driver.
The router cost $180,000 and was expected to save $46,000 a year in outsourced machining, giving a simple annual return of about 25.6% before allowing for maintenance. The vehicle option cost $120,000 in year one including wages and was expected to add roughly $38,000 of annual contribution from faster installations, a return of about 31.7% on that smaller outlay.
The vehicle showed the higher percentage return, but the owner chose the router. In this illustrative example the reasoning was that the vehicle's return depended on winning installation work that had not yet been contracted, while the router's saving was already committed spending she could stop. The case illustrates the standard warning about rate of return: the percentage is only half the decision, and the certainty behind the numerator is the other half.
Watch out
Common mistakes.
- Ignoring income when calculating the return. Dividends, interest and rent are part of the gain, and leaving them out can understate a return substantially over a long holding period.
- Comparing returns earned over different lengths of time. A total return over five years must be annualised before it can be set against a one-year figure.
- Judging investments on return alone. Two investments with the same rate of return are not equivalent if one can lose half its value and the other cannot.
Questions
People also ask.
What is the difference between a nominal and a real rate of return?
A nominal return is the raw percentage, while a real return subtracts inflation, so a 6% nominal return in a year of 4% inflation is close to a 2% real return.
Is rate of return the same as return on investment?
They are used almost interchangeably in everyday business language, though return on investment usually refers to a project or business outlay while rate of return is the broader term covering financial investments as well.
Why do compound and simple returns differ?
Simple returns assume the gain is taken out each period, while compound returns assume it stays invested and earns further returns, which is why the compounded figure is higher over multi-year periods.
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