A rate of return (RoR) is the net gain or loss of an investment over a specified time period, expressed as a percentage of the investment’s initial cost.
For example, the annual rate of return is the percentage change in the value of the investment. If you assume you earn a 15% annual rate of return, then you are assuming that the value of your investment will increase by 15% every year. So, if you invest $1,000 for 1 year, then your investment would be worth $1,150 at the end of the one year period, before subtracting expenses.
A rate of return (RoR) can be applied to any investment vehicle, from real estate to bonds, stocks, and fine art. It can also be applied to a project of implementing a business management software (e.g. Viindoo Business Management Software, Odoo, etc).
In general, the RoR works with any asset provided that the asset is purchased at one point in time and produces cash flow at some point in the future. Investments are assessed based, in part, on past rates of return, which can be compared against assets of the same type to determine which investments are the most attractive. Many investors like to pick a required rate of return (RRR) before making an investment choice.
- RoR is the basis for investors to evaluate the ability of an enterprise to pay interest on the basis of the operating profit of investment activities.
- Helping business managers to assess the impact of financial leverage and make capital raising decisions based on RoR.
- It is an indicator that reflects the efficiency of capital use, from which the investors can assess the profitability of an investment and make the most profitable investment decisions.
When calculating and comparing RoR between investments, people often forget about the time it takes to buy and sell an investment. Accordingly, if the time period between the two investments is different, the result of RoR calculation will no longer be relevant.
Basic Formula to calculate RoR
The formula to calculate the rate of return (RoR) is:
This rate of return is sometimes called the basic growth rate, or return on investment (RoI). If you also consider the effect of the time value of money and inflation, the real rate of return can also be defined as the net amount of discounted cash flows (DCF) received on an investment after adjusting for inflation.