Loading the player...

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.

BREAKING DOWN '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%.

On the other hand, if an investor pays $1,000 for a $1,000 par value 5% bond, the investment earns $50 in interest income per year. If the investor sells the bond for $1,100 and earns $100 in total interest, the investor’s rate of return is the $100 gain plus $100 interest income divided by the $1,000 cost, or 20%.

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.

Assume, for example, a company is considering the purchase of a new piece of equipment for $10,000 and the firm uses a discount rate of 5%. After a $10,000 cash outflow, the equipment increases cash inflows by $2,000 a year for five years. The business applies present value table factors to the $10,000 outflow and to the $2,000 inflow each year for five years. The $2,000 inflow in year five would be discounted using the discount rate at 5% for five years. If the sum of all of the adjusted cash inflows and outflows is greater than zero, the investment is profitable. A positive net cash inflow also means the rate of return is higher than the 5% discount rate.

RELATED TERMS
  1. Discounting

    The process of determining the present value of a payment or ...
  2. Discount Rate

    The interest rate charged to commercial banks and other depository ...
  3. Present Value - PV

    The current worth of a future sum of money or stream of cash ...
  4. Valuation

    The process of determining the current worth of an asset or company. ...
  5. Discount Yield

    Discount yield is a measure of a bond's percentage return. Discount ...
  6. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present ...
Related Articles
  1. Investing

    Key Fundamental Investment Metrics

    Fundamental investors believe certain factors dictate a stock’s performance. There are a few key indicators that fundamental investors should know.
  2. Investing

    Analyze Cash Flow The Easy Way

    Find out how to analyze the way a company spends its money to determine whether there will be any money left for investors.
  3. Investing

    The Essentials Of Corporate Cash Flow

    Tune out the accounting noise and see whether a company is generating the stuff it needs to sustain itself.
  4. Investing

    How to Calculate Required Rate of Return

    Investors use the required rate of return to decide where to put their money, and corporations use it to decide if they should pursue a new project.
  5. Small Business

    Capital Budgeting: Which is Better, IRR or NPV?

    Using internal rate of return and net present value for capital budgeting evaluations often end in the same result. But there are times when using NPV to discount cash flows makes more sense.
  6. Investing

    Why Stocks Outperform Bonds

    Why have stocks historically produced higher returns than bonds? It's all a matter of risk.
  7. Investing

    Discounting With The Discount Rate

    The discount rate is the interest rate you need to earn on a given amount of money today to end up with a given amount of money in the future. Let's say you need $1,000 one year from now to go ...
  8. Investing

    Finding A Discount On Your Next Bond Investment

    Discount rates have nothing to do with buying things on sale. Rather, it helps you figure out how much to pay today for a bond or cash flow in the future.
  9. Investing

    How Interest Rates Affect Property Values

    When interest rates fall, real estate prices tend to increase. Why? Find out here.
  10. Investing

    Analyze Cash Flow The Easy Way

    Cash flow statements reveal how a company spends its money and where that money comes from.
RELATED FAQS
  1. What is the difference between the cost of capital and the discount rate?

    Learn about the differences between the cost of capital and the discount rate as they relate to estimating a required return ... Read Answer >>
  2. How do I calculate free, discounted and operational cash flow in Excel?

    Take a quick look at how you can calculate a company's operating cash flow, free cash flow and discounted cash flows using ... Read Answer >>
  3. What are the disadvantages of using net present value as an investment criterion?

    While net present value (NPV) calculations are useful when you are valuing investment opportunities, the process is by no ... Read Answer >>
  4. When and why should the terminal value be discounted?

    Find out why investors use the terminal value, why the terminal value is discounted to the present day, and how it's related ... Read Answer >>
  5. How do I determine cash flow investing activities for a publicly traded company?

    Learn how cash flows from investing activities are calculated, which sources and uses of cash are included in this section, ... Read Answer >>
  6. What is the difference between operating cash flow and net income?

    Learn how net income is an income statement for a certain period of time, while cash flow shows inflows and outflows based ... Read Answer >>
Hot Definitions
  1. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  2. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  3. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  4. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  5. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  6. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
Trading Center