Methods for calculating rate of return
Your business is growing and it’s time to make some capital improvements. This is where the rate of return (RoR) shines.
What is meant by rate of return?
The rate of return (RoR) is the net gain or loss on your investment calculated over a specific period of time, expressed as a percentage of the initial cost of investment. It’s straightforward enough as a formula. The hard part is working out what the initial cost of your investment was and the current value of the asset.
What is the difference between ROI, RoR, and IRR?
Return on investment (ROI), RoR, and Internal Rate of Return (IRR) are all very similar, but each is used for slightly different purposes when it comes to forecasting and evaluating capital investments.
ROI: Return on investment
This is the simplest of the three formulas and is usually used when an asset is liquidated or as a final figure when an investment project is completed.
ROI = net profitcost of investment 100
Easy. But what ROI doesn’t account for is the length of the investment period or inflation.
Consider the following:
You buy a warehouse for €500,000 and sell it for €750,000. Using the formula, the ROI is 50 percent. Not bad going. A friend does the same, only they buy a warehouse for €400,000 and sell it for €600,000. You have the better investment, right? Not quite. You sold your warehouse after 5 years, which means your annual rate of return was 10 percent. Your friend sold their warehouse after just 2 years, giving them an annual rate of return of 25 percent.
Inflation shouldn’t be much of a factor over a two-year investment, but if you’re looking at five years, ten years, or more, then ROI becomes less and less useful.
RoR: Rate of return
The rate of return calculation is used to determine the growth rate of an investment that is still in progress. Think of it like checking the health of your investment. Is everything working as your predictions suggested or is it time to make adjustments or even pull the plug?
The formula looks like this:
RoR = current value - original valueoriginal value 100
As an example, let’s say you bought a popular domain name for your ecommerce shop. It was expensive, but it should give your search engine optimisation (SEO) a huge boost and make it much easier for customers to find you. You paid €40,000 for the URL two years ago. Let’s say your sales before you bought the domain name was €250,000 per year. Now, your shop is pulling in around €300,000 per year.
Using the formula, the RoR for that investment is (€400,000 - €250,000)/€250,000 or 20 percent.
The ROI would yield a return of 37.5 percent.
IRR: Internal rate of return
The internal rate of return (IRR) is used to account for the effect of inflation on investment profits. It also takes into consideration the length of the investment period. If you know about business forecasting, you might be familiar with the Net Present Value (NPV) calculation.
IRR is NPV if we assume that the NPV equation is also equal to zero.
NPV = t=1T C1(1+r)t -C0 =0
T = total number of time periods
t = time period
C1 =net cash flow in one time period t
C0 =baseline cash flow
r = discount rate
Usually, the higher the internal rate of return, the more desirable an investment is to undertake, and vice versa. As IRR is uniform for investments of varying types, it's useful for accurately ranking multiple prospective investments or projects. You can also use it to understand if establishing a new operation or expanding your existing one would be profitable in the long term.
Nominal rate of return vs. real rate of return
When talking about the rate of return, there’s another important differentiation you need to make. Is the discussion based on the nominal rate of return or the real rate of return?
In the discussion above of different formulas for calculating your expected investment return, we said that the RoR formula didn’t take inflation into account. Return calculations that don’t include inflation as a factor give us a nominal rate of return, or what we would get if everything went perfectly and cash has as much buying power in the future as it does today.
Projections without inflation don’t really reflect real life. If you factor inflation into your calculation, then the figure you get will be the real or inflation-adjusted rate of return.
How to calculate the real rate of return
Here is the formula for calculating the real rate of return based on inflation. Remember, you can only guess at what the actual inflation figure will be, so it’s best to try out a few different scenarios to see where your limits are and if your profit projects are reasonable.
Real rate of return = 1 + nominal rate1 + inflation rate - 1
Let’s use our URL example from the RoR explanation above. We ended up with a 20 percent rate of return. At the moment, inflation in Western Europe is somewhere around eight percent.
Real rate of return = 1 + 0.21 + 0.08 - 1
Real rate of return = (1.2/1.08) - 1
Real rate of return = 11.1%
11 percent is still a very good rate of return, but it’s not nearly as good as the 20 percent you expected.
What is a good rate of return?
There is no objectively good rate of return. There are only rates of return that make sense for your business. Higher returns usually mean higher risk, for example. Lower returns that hold steady for many years without much additional work from you could make you heaps more money in the end over higher return/resource-heavy arrangements. Your industry can also impact the perceived value of a return. Some high volume/low margin businesses would be elated with a one percent gain. Less competitive, more niche businesses might consider anything less than 10 percent not even worth the effort.
Consider the following questions to determine if the RoR you calculated for your investment is right for your business.
- How much risk are you willing to take on?
- What will happen if you lose the money you invest?
- How much profit will you need from the investment to avoid losing money?
- What else can you do with the money if you don’t make the specific investment?
Aside from that, find an accountant and business manager you trust, get good advice, and see what your business can build.
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