A good reason for investing in stocks is to earn more money than the interest paid by a bank account or savings bonds. Some investors ignore their stocks until it’s time to cash in. Most prefer to watch the growth of returns, in which case they need to know the total return and holding period.
Stock profits depend on the capital gains and dividends. A capital gain is the amount earned when the current stock price exceeds its purchase price. A capital loss is the amount lost when a current price is below the purchase price. The capital gain (or loss) is “unrealized” if the investor doesn’t sell the stock or “realized” if the investor sold the stock. Some companies make occasional cash payments, called dividends, to their stock holders.
Total Return is the total profit from your stock investment. It represents the stock’s change in market value combined with all dividends you received from the company. In equation 1, the change in market value is equal to “market value – total cost”.
total return = market value – total cost + dividends
- Market value is the combined value of all shares owned at the current market price (market value = current price * volume; volume is the number of shares).
- Total cost is the value of all shares purchased (cost = purchase price * volume) during the holding period
- Holding period is the period of stock ownership.
Trading fees are ignored in order to simplify this discussion. In actual transactions, trading fees reduce the market value and increase the cost by small amounts so as to reduce the total return by a small amount. The impact of trading fees on profits is lower in larger transactions. For example, a $5.00 trading fee is 5% of a $100 purchase compared to 0.5% of a $1,000 purchase.
Return on Investment (ROI)
ROI is the basic measurement of profitability (ref 1). It is the ratio of total return to total cost (equation 2).
ROI = total return/total cost
Significance: the ROI shows how much profit you earned from every invested dollar. If the ROI were 0.2/1, which is 20%, then you earned 20 cents per invested dollar.
“Price performance” (equation 3) may not measure the ROI. Price performance = (price2 – price1)/price1, where price1 is the earlier number and price2 is the later number. Price 1 may neither be the purchase price nor the only purchase price. ROI includes all purchase prices.
Rate of Return
The rate of return measures profitability with respect to time. Think of if it as the ROI for the holding period (equation 4).
Rate of Return = ROI/holding period
Don’t forget that the ROI compares profit to cost when the time period is anchored to the date of the initial purchase.
ISSUE: The rate of return is most precise when there is just one purchase. Serial purchases require a more complicated calculation of the “annual return”.
The annual return is a number that represents the average rate of growth per year of the holding period. The annual return has several important properties:
- It doesn’t change during the holding period.
- It’s a geometric average, not an arithmetic average. The graph of geometric growth is a curved line (“exponential”) rather than a straight line (“linear”).
- The geometric average represents the phenomenon of compounded growth known as “compounded interest”.
Stock investors are interested in 2 types of compounded growth:
- The compound annual growth rate (“CAGR”) of a single purchase.
- The internal rate of return (“IRR”) for a series of purchases.
ISSUE: The annual return is usually inaccurate during the first year of compounded growth and becomes more accurate over longer time periods.
Rule of 72
The payback period is something to celebrate! It’s the point when the investment doubles your money. Payback is measured by the ratio of total cost to the rate of return. Or, it can be estimated by the Rule of 72 (equation 5).
Rule of 72 = 72/assumed annual return
Significance: the Rule of 72 is used to forecast the holding period needed to double your money (ref. 4). For example, assume that your total return will grow at a constant rate of 10% per year [approximately the same rate as the growth of the U.S. Stock Market]. The expected payback period is 7.2 years (7.2 = 72/10).
The total profit of your stock investment is called the total return. The simplest way to measure profitability is to calculate the ROI with equation 2. The ROI is insensitive to time until you calculate the rate of return with equation 4, which allows you to compare the profitability of several stocks in your portfolio. The annual return of compounded growth is a refined measurement of your calculated rate of return. After a holding period beyond one year [to avoid the chance of considerable inaccuracy], the annual return may be determined with an online calculator for a single investment (CAGR) or serial investments (IRR).
1. Return on Investment (ROI). https://www.investopedia.com/terms/r/returnoninvestment.asp
2. Compound annual growth rate (CAGR) calculator. http://www.moneychimp.com/calculator/discount_rate_calculator.htm .
3. XIRR calculator to calculate IRR of non-periodic cash flows. https://www.free-online-calculator-use.com/xirr-calculator.html .
4. Brian Beers. What is the Rule of 72? https://www.investopedia.com/ask/answers/what-is-the-rule-72/ , 1/2/2018.
Copyright © 2018 Douglas R. Knight