QFINANCE Topics
• Balance Sheets and Cash Flow
• Financial Markets
• Financial Regulation and Compliance
• Funding and Investment
• Governance and Ethics
• Mergers and Acquisitions
• Operations and Performance
QFINANCE Reference
• Research Data
• Financial Reference

Home > QFINANCE Dictionary > Definition of rate of return

Definition of

# rate of return

Accounting

ratio of investment profit to investment cost an accounting ratio of the income from an investment to the amount of the investment, used to measure financial performance.

There is a basic formula that will serve most needs, at least initially:

[(Current value of amount invested − Original value of amount invested) / Original value of amount invested] × 100% = Rate of return

If \$1,000 in capital is invested in stock, and one year later the investment yields \$1,100, the rate of return of the investment is calculated like this:

[(1,100 − 1,000) / 1,000] × 100% = 100 / 1,000 × 100% = 10%

Now, assume \$1,000 is invested again. One year later, the investment grows to \$2,000 in value, but after another year the value of the investment falls to \$1,200. The rate of return after the first year is:

[(2,000 − 1,000) / 1,000] × 100% = 100%

The rate of return after the second year is:

[(1,200 − 2,000) / 2,000] × 100% = −40%

The average annual return for the two years (also known as average annual arithmetic return) can be calculated using this formula:

(Rate of return for year 1 + Rate of return for year 2) / 2 = Average annual return

Accordingly:

(100% + −40%) / 2 = 30%

The average annual rate of return is a percentage, but one that is accurate over only a short period, so this method should be used accordingly.

The geometric or compound rate of return is a better yardstick for measuring investments over the long term, and takes into account the effects of compounding. This formula is more complex and technical.

The real rate of return is the annual return realized on an investment, adjusted for changes in the price due to inflation. If 10% is earned on an investment but inflation is 2%, then the real rate of return is actually 8%.

#### Related definitions of "rate of return"

• Valuing Pension Fund Liabilities on the Balance Sheet

With a pension plan, companies agree to provide certain benefits to their employees, by specifying either a defined contribution (where a fixed contribution is made to the plan each year by the employer, with no promises as to the future benefits that will be delivered by the plan) or a defined benefit (where the employer undertakes to pay a certain benefit to the employee at some point in the future). Under the latter, the employer has to put...
• Using IRR for M&A Financing
This checklist considers the strengths and weaknesses of using the internal rate of return as a yardstick when financing mergers and acquisitions.
• Appraising Investment Opportunities
This checklist outlines how to appraise investment opportunities.
• Understanding the True Cost of Issuing Convertible Debt and Other Equity-Linked Financing

Convertible securities (CSs) and other equity-linked instruments combine debt and equity. Depending on the terms and the issuer’s future performance, CSs can range from almost pure equity to an option-free bond. In option terms, a CS can be viewed in two ways. It amounts to a straight bond with a call option on a specified number of shares. It is also effectively a share with a put option whose exercise price is the market value of the...

Definitions of ’rate of return’ and meaning of ’rate of return’ are from the book publication, QFINANCE – The Ultimate Resource, © 2009 Bloomsbury Information Ltd. Find definitions for ’rate of return’ and other financial terms with our online QFINANCE Financial Dictionary.

## Related Dictionary Terms

Related Dictionary Terms

## Related Blog Posts

More related Blog results