What is a ‘Rate Of Return’
A rate of return is the gain or loss on an investment over a specified time period, expressed as a percentage of the investment’s cost. Gains on investments are defined as income received plus any capital gains realized on the sale of the investment. Rate of return can also be defined as the net amount of discounted cash flows received on an investment.
Explaining ‘Rate Of Return’
A rate of return can be applied to any investment vehicle, from real estate to bonds, stocks and fine art, provided 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.
The Differences Between Stocks and Bonds
The rate of return calculation for stocks and bonds is slightly different. Assume an investor buys a stock for $60 a share, owns the stock for five years, and earns $10 in total dividends. If the investor sells the stock for $80, he has a $20 per share gain and has earned another $10 in income. The rate of return for the stock is $30 per share divided by the $60 cost per share, or 50%.
How to Discount Cash Flows
Discounted cash flows take the earnings on an investment and discount each of the cash flows based on a discount rate. The discount rate represents a minimum rate of return acceptable to the investor, or an assumed rate of inflation. In addition to investors, businesses use discounted cash flows to assess the profitability of a company’s investment.
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