Investment Returns
by MaestriWith most investments, an individual or business spends money today with the expectation of earning even more money in the future. The concept of return provides investors with a convenient way of expressing the financial performance of an investment. To illustrate, suppose you buy 10 shares of a stock for $1,000. The stock pays no dividends, but at the end of one year, you sell the stock for $1,100. What is the return on your $1,000 investment?
If at the end of the year you had sold the stock for only $900, your dollar return would have been $100.
Although expressing returns in dollars is easy, two problems arise: (1) To make a meaningful judgment about the return, you need to know the scale (size) of the investment; a $100 return on a $100 investment is a good return (assuming the investment is held for one year), but a $100 return on a $10,000 investment would be a poor return. (2) You also need to know the timing of the return; a $100 return on a $100 investment is a very good return if it occurs after one year, but the same dollar return after 20 years would not be very good.
The rate of return calculation “standardizes” the return by considering the return per unit of investment. In this example, the return of 0.10, or 10 percent, indicates that each dollar invested will earn 0.10($1.00) $0.10. If the rate of return had been negative, this would indicate that the original investment was not even recovered. For example, selling the stock for only $900 results in a minus 10 percent rate of return, which means that each invested dollar lost 10 cents.
Note also that a $10 return on a $100 investment produces a 10 percent rate of return, while a $10 return on a $1,000 investment results in a rate of return of only 1 percent. Thus, the percentage return takes account of the size of the investment.
Expressing rates of return on an annual basis, which is typically done in practice, solves the timing problem. A $10 return after one year on a $100 investment results in a 10 percent annual rate of return, while a $10 return after five years yields only a 1.9 percent annual rate of return.
Although we illustrated return concepts with one outflow and one inflow, rate of return concepts can easily be applied in situations where multiple cash flows occur over time. For example, when Intel makes an investment in new chip-making technology, the investment is made over several years and the resulting inflows occur over even more years. For now, it is sufficient to recognize that the rate of return solves the
two major problems associated with dollar returns—size and timing. Therefore, the rate of return is the most common measure of investment performance.
Taken From : Five-Minute MBA – Corporate Finance
Related posts:
- Pure Water And Employee Productivity: A Good Investment In a competitive world productivity is king. When employees are...
Related posts brought to you by Yet Another Related Posts Plugin.
