What is a financial return?
A financial return commonly called return and also referred to as return on investment, is the amount of money gained or lost on an investment over a given period of time.
In the description of return above, the term investment is used in its broad sense, meaning something an investor puts his or her money into and expect some type of return. Hence, investment can imply investments, securities such as shares, and assets like property. It also includes investments by companies such as equipment, trademarks, patents, or projects.
A financial return can be expressed in two ways:
- in the form of a percentage change, usually referred to as the rate of return (ROR), or
- in terms of a change in the nominal value of an investment over a certain period of time.
Some terms regarding return explained
What is a positive return?
A positive return indicates a profit on an investment. Put differently, a positive return means the investment an individual or business invested in generates more money than the individual or business has put into it.
What is a negative return?
A negative return occurs when an investor suffers a decline in the value of the investment invested in.
What is a holding period return?
A holding period return refers to the return of an investment over the period of time it is owned by a specific investor.
For instance, the return gained during a month is called a monthly return and when the financial return is earned during a year, it is called an annual or yearly return. Typically, investors are keen to know the annual return of an investment, or year-on-year (YoY) return, which compares the return on investment on a specific date in a year to the same date of the previous year.
To compare ‘apples with apples’, returns over different periods of time have to be converted to the same time frames, typically to year-long time intervals. This type of conversion is referred to as annualization.
What is a nominal return?
A nominal return is the amount of South African rands (ZAR) (or US dollars or any other applicable currency) gained or lost on a particular investment before any adjustments for expenses (fees, taxes, and acquiring costs), dividends or interest received.
In other words, nominal return only presents the change in the price of an investment.
The nominal return also excludes the effect of inflation.
For example, investor A has purchased 200 shares that cost R10 each. A year later the share price is R17, and the investor decides to sell the shares. Assuming there are no costs, dividends, or interest involved, the nominal return of the investment is R3 400 (200 shares x R17) – R2 000 (200 shares x R10) = R1 400.
The nominal return can also be expressed as the nominal rate of return, sometimes referred to as the ‘face amount of a return.’
The nominal rate of return of investor A’s investment will be calculated as follows:
Nominal rate of return = (Current investment value/Original investment value) – 1
= (3 400/2 000) – 1
= 1.7 – 1
= 0.7 or 70%
What is the real rate of return?
Simply put, the real rate of return is obtained by adjusting the nominal rate to compensate for inflation.
The real rate of return is considered the actual increase in the value of an investment, depicting a more accurate picture of the value of an investment – especially during times of high inflation.
Example:
Sarah invested in a security that yields an annual return of 8%. The rate of inflation for the same year is 4%.
The nominal rate of return of Sarah’s investment is 8%.
The real rate of return of the investment is 4%, meaning that the actual increase of Sarah’s investment is 4% and not 8% as indicated by the nominal rate of return.
Return ratios
Return ratios are part of a larger set of financial ratios, measuring how effectively an investment is being managed.
Return on investment (ROI)
Return on investment (ROI) enables investors to decide whether an investment is a good opportunity to gain a profit. The ratio can also indicate how an investment has performed over a given period of time.
Typically, ROI is calculated by using one of the following two formulas:
ROI = Net income/Capital cost of investment
or
ROI = Investment gain/Initial investment
Where:
The initial investment is also referred to as the investment base.
The first ROI ratio is the most commonly used ROI ratio.
Example of the second ROI ratio (the investment gain formula):
An investor acquires a property, valued at R1 500 000. Three years later the property is sold for R 1 900 000. Thus, the investor’s gain on the property is R400 000 (R1 900 000 – R1 500 000).
ROI = R400 000/R1 500 000
= 0.27
= 27%
The higher the ratio, the greater the profit earned.
Return on assets (ROA)
The return on assets (ROA) ratio is a financial ratio that measures the profitability of a business compared to its assets.
Put differently, ROA indicates how much net profit is generated by a business for each South African rand (ZAR) (or any other applicable currency) for each ZAR invested in assets.
The ROA formula is:
ROA = Net income/Average assets
Where:
Average assets = Closing balance of assets minus opening balance of assets of a particular accounting period divided by 2.
Example:
Company Rock-Steady reported, inter alia, the following annual figures:
- Net income: R250 000
- Average assets: R650 000
ROA = R250 000/R650 000
= 0.38
= 38%
This means that for every South African rand (ZAR) of assets company Rock-Steady invests in, it has a return of 38 cents in net profit per year.
Return on equity
Return on equity (ROE) is a calculation that indicates how much net income is generated per ZAR (or any other applicable currency) of a company’s shareholders’ equity, expressed as a percentage.
The formula to measure ROE is:
ROE = Net income/Shareholders’ equity
Example:
The ROE of a company with an annual net income of R150 000 and shareholders’ equity of R500 000 will look as follows:
ROE = R150 000/R500 000
= 0.3 x 100
= 30%
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