The yield rate It is the net profit or loss of an investment during a specified period of time, which is expressed as a percentage of the initial cost of the investment. The time period is usually one year, in which case it is called the annual return..
Investment gains are defined as the income received plus the capital gain from the sale of the investment. The rate of return is sometimes called return on investment or ROI.
In finance, performance is a return on an investment. It comprises any change in the value of the investment and / or the cash flows that the investor receives from the investment, such as interest or dividend payments..
A loss rather than a gain is described as a negative return, assuming the amount invested is greater than zero..
To compare returns over time periods of different durations on an equal basis, it is useful to convert each return to an annualized return. This conversion process is called annualization..
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The rate of return can be applied to any type of investment, from real estate to bonds, stocks and works of art, as long as the asset that is bought at any given time produces a cash flow in the future.
Rates of return are useful for making investment decisions. For nominal risk investments, such as savings accounts, the investor considers the effect of reinvesting. Thus, it increases savings balances over time to project expected future earnings..
For investments where capital is at risk, such as stocks and home purchases, the investor also takes into account the effects of price volatility and risk of loss..
The metrics that financial analysts use to compare a company's performance over time, or to compare performance across companies, are return on investment, return on equity, and return on assets..
In the capital budgeting process, companies compare the rates of return of different projects to decide which projects to pursue to maximize the company's return..
The rate of return used to purchase a home is considered a nominal rate of return. This is because it does not take into account the effect of inflation over time..
Inflation reduces the purchasing power of money. Therefore, the amount of the sale of the house in six years will not be the same as that same amount today. Similarly, the amount of the home purchase today is not worth the same amount as that same amount six years from now..
Discounting is a way of accounting for the value of money over time. Once the effect of inflation is taken into account, the rate of return will be called real, or adjusted for inflation..
The formula used to calculate the rate of return is as follows:
Rate of return = ((Final investment value - Initial investment value) / Initial investment value) x 100.
Taking into account the effect of time value of money and inflation, the real rate of return can also be defined as the net amount of cash flows received on an investment after adjusting for inflation..
The rate of return can be calculated for any investment, dealing with any type of asset.
A concept closely related to the rate of return is the compound annual growth rate, or CAGR. This is the annual average rate of return on an investment during a certain period of time, greater than one year..
To calculate the compound annual growth rate, the value of an investment at the end of the period in question is divided by its value at the beginning of that period. The result is then raised to the power of one divided by the length of the period. Finally one is subtracted from that result. This can be written as follows:
CAGR = ((Final value / Initial value) ^ (1 / Number of years)) - 1
Buying a home is a basic example for understanding how to calculate the rate of return. Let's say you buy a house for $ 250,000. Six years later, it is decided to sell the house. The family is growing and a bigger place is needed.
The house can be sold for $ 335,000, after deducting the realtor's taxes. The rate of return on buying and selling the home is: ((335,000-250,000) / 250,000) x 100 = 34%.
Now what if the house were sold for less than what it was paid for? Let's say it sells for $ 187,500. The same equation can be used to calculate the loss, or negative rate of return, on the transaction: (187,500-250,000) / 250,000 x 100 = -25%.
Adam is a retail investor and decides to buy 10 shares of ABC Company at a unit price of $ 20. Adam has shares in Company ABC for 2 years. In that period, the ABC Company paid annual dividends of $ 1 per share.
After holding them for 2 years, Adam decides to sell the 10 shares of ABC Company at an ex-dividend price of $ 25. Adam would like to determine the rate of return during the two years he owned the shares.
To determine the rate of return, you first calculate the amount of dividends you received over the two-year period: 10 shares x ($ 1 annual dividend x 2) = $ 20 in dividends of 10 shares
Then, it is calculated how much the shares were sold for. 10 shares x $ 25 = $ 250 (profit from sale of 10 shares).
Finally, it is determined how much it cost Adam to buy the 10 shares of ABC Company. 10 shares x $ 20 = $ 200 (cost of buying 10 shares)
Plug in all the numbers in the rate of return formula: (($ 250 + $ 20- $ 200) / $ 200) x 100 = 35%
Therefore, Adam earned a 35% return on his shares over the two-year period..
Applying the formula, the annualized rate of return would be as follows: ((($ 250 + $ 20) / $ 200) ^ 1/2) - 1 = 16.1895%
Therefore, Adam obtained an annualized rate of return of 16.1895% on his investment..
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