How to Calculate the Rate of Return: Definition, Formula & Example
In this lesson, we will define the rate of return and explore how it’s used in today’s business decisions. Using the formula and an example, we’ll learn how to calculate the rate of return to determine if a particular business decision is a wise one.
What is the Rate of Return?
The rate of return is the amount you receive after the cost of an initial investment, calculated in the form of a percentage. The percentage can be reflected as a positive, which is considered a gain or profit. When the percentage is negative, it reflects a loss. This information is very useful in determining whether or not the initial investment you made was a good one.
Why Calculate It?
There are many reasons why it would be advantageous to know the rate of return on your investment. After all, how would you know if your investment was a wise choice? Calculating the rate of return provides important information that can be used for future investments. For example, if you invested in a stock that showed a substantial gain after several months of performance, you may decide to purchase more of that stock. If the stock showed a continual loss, it may be wise to conduct research to find a better-performing stock.
Another advantage of calculating the rate of return is that it allows you to gauge your investment and decision-making skills. Investments that create a gain or profit are great. However, if you continually make investments at a loss, then you may want to change your investment strategies. A great attribute of successful business people is knowing how and when to make investments, as is knowing when to change strategies. With a firm grasp of calculating the rate of return, you can manage and monitor your investments at various stages to determine the outcome of your investments. This leads to a higher level of confidence and the skills necessary to be a savvy investor.
The Rate of Return Formula
The rate of return formula is an easy-to-use tool. There are two major numbers needed to calculate the rate of return:
Current value: the current value of the item.
Original value: the price at which you purchased the item.
Then, apply these values to the rate of return formula:
((Current value – original value) / original value) x 100 = rate of return
Remember, the outcome is always reflected as a percentage, so the formula requires you to multiply by 100 to get the percentage. If this percentage is a positive number, then you have a profit or gain on your investment. If the percentage is a negative number, then you have a loss on the investment.
Example
Let’s say that in 2002 you purchased a home for $200,000. In the next few years, homes in your neighborhood have been selling well due to the new shopping plaza a couple of miles away, which increased the market value of your home. So in 2007, you decided to downsize and sell your home. Based on the current market value during this time, you were able to sell your home for $250,000. Using the formula, let’s calculate the rate of return on your investment:
Current value = 250,000
Original value = 200,000
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