Whenever you are investing in a stock, you always check how much profit you are gaining. To know your profit or loss amount, you need to calculate stock return. Calculating your stock return can help you measure the performance of the stock.
However, due to the lack of knowledge, many investors have little clarity to calculate their ROI. In this blog, we will try to use different methods of calculating stock return. This will help you choose stocks that have better ROI.
The need to calculate the return of a stock
The rate of return (ROR) can be considered a measuring tool of your gains and losses after you invest for a time period. Before calculating the investment returns, you must be aware of the types of return rates associated with the stock market investment opportunities.
The amount of money generated by potential investments you make for a period before factoring in expenses like investment fees, taxes, and inflation is called the nominal rate of investment returns. So, for example, if you generate a 15% return, the nominal rate would equal 15%.
On the other hand, the real or actual return refers to the amount you make after factoring in the inflation, taxes, and investment fees. Therefore, the real return is always lower than the nominal rate of return.
The nominal ROI figure allows investors to calculate and compare the performance of an invested capital keeping tax rates and other fees out of the picture. Therefore, in order to get an average picture of the contemporary stock market rates, the nominal rates are taken into consideration.
The nominal rate of return also helps you analyze your overall portfolio and better understand your investments, bonds, and stocks.
Why’s a nominal rate of return not enough?
However, Since the nominal rate of return does not include taxes or inflation rates, it cannot give you the overall picture. For instance, you earned 10% over a year, and the inflation rate was 2.5%. Now, the actual return rate will turn out to be 7.50% (10%-2.5%.) This actual number is not given to you by the nominal return rate.
Return on investment refers to the return on investment performance used by investors to evaluate and compare different investments in the contemporary stock market.
ROA, ROE, and IRR
ROA refers to the return of assets. It is a type of return on investment metric used to measure the ability to make profits of a business. It is calculated by keeping the total assets of the business in mind.
ROE, i.e. return on equity, can be considered to be a measure that evaluates a company’s profitability by taking the annual return and dividing it by its total shareholders’ equity and the value.
IRR refers to the internal rate of return. The discount rate makes the NPV value of a project zero. Therefore, it is a compound annual rate of return that his aunt per investment or project.
How to calculate the return of a stock?
There are multiple formulas to calculate different kinds of return rates when it comes to stocks.
The standard formula to calculate the rate of return:
Rate of Return (ROR)
= (Ending Value of Investment- Beginning Value of Investment × 100%) / Beginning Value of Investment
This is the easiest and one of the most common ways to calculate the rate of a stock’s total return.
Second Method to calculate the return on investment:
Return on Investment (ROI)
= Cost of Investment ×100% / Net Return on Investment
Please note that The calculated rate is expressed as a percentage, for it is easier to understand compared to ratio results.
Third Method to calculate the total stock return:
Total Stock Return = Dividend Yield + Capital Gains Yield
The capital gains may come across as the percentage change in your stock price. This alternative formula comes from the separation of stock appreciation and dividends.
When the ROI calculations come as a positive figure, it indicates that the net returns are in Black, i.e. the total returns exceed total costs. On the other hand, if the calculations come as a negative figure, it indicates that the returns are in Red, i.e. the total costs have exceeded the total return amounts. This is the easiest way to analyze the ROR of a stock.
In order to calculate your ROI correctly, make sure you take the total costs and the total returns into consideration.
For instance, an investor buys 1000 shares of a company at the rate of 10 rupees per share. One year later, the investor decides to sell his shares at the rate of 12.5 rupees per share. This week, the investor will be able to earn dividends of up to ₹500. The investor must spend around ₹125 for trading commissions while buying and selling shares.
The ROI calculation of the investment can be done in this way:
Return on Investment (ROI)
= (₹12.50 –₹10) × 1000 + ₹500 – ₹125 × 100 / ₹10 × 1000
This way, the Return on Investment (ROI)can be calculated and used for further evaluation of an investor’s portfolio.
Pros and Cons
One of the biggest benefits of ROI is that it is an uncomplicated metric. It is easy to calculate and can be calculated even by beginners. This is the reason the standard ROI calculation formula is followed universally by almost all investors on a global level.
However, one of the significant disadvantages of calculating Return on Investment (ROI) is that it does not take into account the span of time, i.e. the holding period of an investment. This is an issue that prevents accurate calculation in the long run.
On the other hand, another disadvantage of the standard or formula is that it does not adjust for risk. Stock investment has a direct correlation with risk factors. Apart from that, the ROI figures can also be extended irrationally if and when the expected costs are not taken into consideration during the calculation.
Example of Rate of Return (ROR) Calculation
The most common way to calculate the rate of return is by taking the beginning value of an investment and the ending value of the investment into consideration.
For instance, you are a retail investor, and you buy 10 shares of a company at the share price of ₹20 per unit. Then, you hold on to your stock for around two years and decide to sell it at the price of ₹25 per share. In the meantime, the dividends paid by the company were around one rupee per share.
Now in order to calculate the ROR, you have to follow the following formula:
10 Shares × ( ₹1 annual dividend × 2 ) = ₹20 in dividends from the 10 stocks
Now, after calculating the number of dividends you receive, calculate how much you get by selling the shares:
10 shares × ₹25 = ₹250 (you gain this amount by selling the shares.)
Now, you have to calculate how much it cost you in the first place to purchase all the 10 shares of the company:
10 shares × ₹20 = ₹200 (this much you spent while purchasing the shares)
Finally, plug all the numbers together in order to calculate the rate of return:
(( ₹250 + ₹20 – ₹200 ) / ₹200 ) × 100 = 35%
How to calculate Annualized ROI?
The basic ROI calculation comes with an obvious limitation- it does not consider the length of time of investments, also known as the holding period. This is why many investors rely on calculating annualized ROI before investing in a stock.
The standard formula to calculate the annualized ROI:
Annualised ROI = [(1+ROI) 1/n – 1] × 100%
Here, the N stands for the total number of years the investment is held, i.e. holding period. This is the universal formula that is followed in order to calculate the true annualized ROI.
For instance, assume a hypothetical situation where an investment ends up generating an ROI of 50% for around five years. Then, the simple annual average ROI of 10% was obtained after dividing the ROI by the holding period of 5 years- is a rough calculation of the annualized ROI.
If the time period gets longer, the difference between the annualized proper ROI and the approximate average ROI becomes wider.
Comparison between Annualized ROI and Investments
The annualized ROI calculation can be beneficial if you compare returns among various investments when it comes to evaluating different investments.
For instance, if stock Y generates an ROI of around 50% for 5 years of holding period and stock Z returns 30% over a span of 3 years, You can quickly determine which investment was better by calculating the ROI using the following formula:
ROI for stock Y= [( 1+ 0.50%) ⅕ -1 ] × 100 = 8.45%
ROI for stock Z= [( 1+ 0.30) ⅓ -1 ] × 100 = 9.14%
As per the calculation, stock Z seems to have a superior ROI compared to stock Y.
On the other hand, you can also combine leverage with ROI. Leverage is the ability to magnify the ROI when your investment ends up generating gains. Conversely, leverage can also amplify losses if your investment fails to generate gains and proves to be a losing one in the long run.
For instance, suppose an investor buys 1000 shares of a company at the cost of ₹10 per share. The investor buys these shares on a 50% margin- They invest ₹5000 from their own capital and borrow around ₹5000 from other brokerage firms as a margin loan. Now, they decide to sell the shares at the cost of ₹12.50 per share to another buyer.
In this case, they will earn dividends of up to ₹500 for a holding period of around one year. They will also have to spend around ₹125 on commission fees for buying and selling his shares. If the margin loan is carried on for an interest rate of 9%, you can calculate return on investment in the following method:
= (₹12.5 – ₹10) × 1000+ ₹500 – ₹125 – ₹450 × 100 / (₹10 × 1000) – (₹10 × 500)
In this case, the 9% interest rate of the margin loan is also considered while calculating the ROI. On the other hand, the initial investment becomes ₹5000, for this is the amount that the investor paid from his own capital.
This way, the ROI remains 48.5%, which is higher than 28.75% if no leverage was there in the first place.
Initial Investment in Stock Market & Calculating Capital Gains
If you are a new investor who has no prior experience investing in stocks, make sure you do sufficient research about the contemporary market rates and the benefits and losses of the company you are planning to invest in. Then, you can follow the standard formula to calculate the stock return and evaluate your portfolio accordingly.
Despite all the limitations, the standard ROI formula remains one of the most used and universal formulas. The fact that it is a straightforward calculation that can be quickly followed even by beginners makes it feasible.
Playing it Safe
Stock market investment is something that solely caters to matured and experienced investors because investing in stocks comes with high-risk factors and unpredictability. Therefore, you only want to rely on a low risk investment and invest money in the stock market that you will not require soon.
More investors, More investment options, More money
On average, the United States represents almost 54% of the global market scenario, and around 10% of US households hold international equity. In 2020, the number of individual investors went on to reach 1,37,000 crore in India. As the stats prove, the investors in this field have grown immensely in numbers. This is because the possibilities of the industry have slowly been exposed to the common mass globally.
If you have recently started investing in the market and are wondering how to calculate the return of a stock correctly, we have got you covered. Read on to find out all the necessary details regarding the calculation of stock returns along with other significant factors that will help you become a better investor in the future.
Things to Remember During Stock Investment
If you are a potential investor who has no foundational idea of the entire process you are exposed to after owning a stock, make sure you first understand the whole process before initial investment.
There are a plethora of misconceptions that new investors often have, which affect their investment journey quite a lot in the long run.
Stock Market Tips and Basic Fundamentals
- When you own a stock, you buy a percentage of ownership in a company at a certain purchase price.
- The stock market runs because of the different opinions of different people. For instance, you want to be a seller of Infosys stock. Someone else will be a buyer of the same stock. The stock exchange will take place based on your requirements and a convincing selling price.
- The most common way to set the share price is to place bids through an auction process.
- Your level of ownership does not translate into responsibilities and benefits after you buy a stock. It also varies from one investor to the other depending on the company’s policies.
- Being a shareholder of a company does not mean you will be offered special discounts on the products the company produces.
- Many new investors tend to have a common misconception that investing in stock brings easy money. It is not the case. Instead, when you invest in a stock, you have to be patient enough to acknowledge the fact that results in the stock market take time.
- The stock market is unpredictable and quite risky. And you have to take risks if you invest in stocks. As Robert Arnott puts it, “In investing, what is comfortable is rarely profitable.”
- Suppose you have a long-term strategic plan for investments. In that case, you can easily make a profit in the current market scenario despite all the risk factors associated with the stock market.
- Buying a stock makes you a shareholder of the company and not a boss. Do not overestimate your position, and make sure you understand your role well.
- If you are not happy with a company’s management after you buy a share, you can always sell it to someone who is interested. And if you are satisfied with the way the management works, hold on to your stock and expect a good return.
- Capital gains take place when you sell a stock at a comparatively higher price than the price you bought it at in the first place.
- You have to do market research thoroughly before investing in a stock. The market price may go up and down depending on several factors after buying a share of any company. Accepting the changes and moving on is the best way to deal with such situations.
- Therefore, after you own a stock, you have to constantly be aware of the market prices and analyze whether you will have significant profits in the long term or not. If you do not see a positive future, you have to sell it to someone at a higher price to raise capital gains.
- The number of stocks does not diversify your portfolio. Although it is valid to a certain extent, the major determining factor here is how uncorrelated all your stocks are.
As McGinnin says, “Timing the market is incredibly difficult, as it’s actually two decisions to be made: when to get out and when to buy back in.”
Whether you own a stock or are planning to invest soon, make sure you remember that nobody can actually predict the future of the market. No matter how much research you do and what other investors have to say, the market is highly unpredictable, and all we have to do is accept it and find our way back in once the situation is better.