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.