Understanding Returns

Understanding Returns – Absolute Return, CAGR, IRR etc

Understanding Returns: People invest their money in different platforms with the objective to earn returns. Before investing, one has to calculate his/her return from different platforms so that he/she can make the right investment choice. There are different ways that are used for calculating returns, such as CAGR, XIRR, Rolling Returns. For example, people usually prefer simple point-to-point returns (absolute returns) when the investment period is less than one year, and they prefer CAGR in the case of long-term investments. In this article, we will discuss some ways that are used for calculating returns for the purpose of comparison.

How to Calculate Returns?

Return is considered to be the gain or loss of an investor, which is calculated in the value of an asset over a period of time. Returns are generally represented in the form of a percentage. In simple words, the investment return is considered to be the change in the value of investment money over a period of time. For example, Rohan invested 10000/- in a mutual fund, and after holding it for 2 years, the invested money became 20000/-

The general rule which most investors are aware of is that the more risk one takes, he/she becomes more potential to earn higher returns. This return might also turn into loss if things go sideways. Return on investment seems to have two basic components:-

Interest or dividends – This is the income that is generated by the underlying investment.

Appreciation (Depreciation) – This is considered to be an increase or decrease in the value of an investment.

Necessary To Find Return On Investment

It is necessary to find the return on investment because:

  • calculating the return on investment plays a key role in the investment review planning process. This will help a person to know whether his/her investments are on the right track or not. If they are not on track, then he/she needs to make the necessary adjustments as soon as possible.
  • calculating the return on investment also helps in making the right investment choice among the options that are available in the market, such as investment in gold, real estate, stocks, mutual funds, etc.

Absolute Return

Absolute return is considered to be the increase or decrease in the value of an investment over a particular period of time. This return is expressed in percentage terms. This return seems to get calculated through the following process:

Absolute returns = 100 × (Selling Price – Cost Price) / (Cost Price)

For example, A person invested in an asset in January 2013 at a price of  Rs 12000.  And you sold the investment in January 2020 at the cost of Rs 32000. Absolute returns, in this case, will be:

Absolute return = 100 × (32000 – 12000)/12000

= 100 × (20000/12000)

=  166.67%

This technique of measuring the return on investment is the simplest as it doesn’t consider the time period. Most of the time, this technique shows a huge amount of return, thus making people excited and impressed.

Simple Annualised Return

This is considered to be the increase in the value of a particular investment. This seems to be expressed as a percentage per year.

Simple Annualized Return = Absolute Returns calculated / Time period given.

Suppose investment of Rs 1,00,000  becomes 1,30,000 over three years.

Absolute Return = 100 × ( 130000 – 100000/100000 ) = 30%

Simple Annualised Return = 30/3 = 10%

Average Annual Return (AAR)

Average Annual Return is considered as the average of a series of the rate of returns on a particular investment over a period of time. The formula of AAR is as follows:

AAR = (Return from Period 1 + Return from Period 2 + Return from Period 3 + …Return from Period N) / Number of Periods or N

Assume that an investment ABC seems to records the following annual returns:

Year Annual Return
2017 20%
2018 25%
2019 22%
2020 21%

AAR = (20% + 25% + 22% + 21%) / 4

= 88/4

= 22%

Compound Annual Growth Rate (GAGR)

CAGR is considered to be the year over the year growth rate of a particular investment over a specific period of time. It is considered as an imaginary number that is meant for describing the rate at which the investment must have grown if it grew at a steady pace.

Let’s assume a person invested Rs 10,000 in Apr 2019, and by Apr 2020, his/her investment became Rs 30,000; by Apr 2022, it became Rs 15,000. Calculate the return on investment for the period.

Description Profit/Loss ( In a particular period) Initial Amount for the particular period Profit/loss percentage in that period
Return in 2019 – 20 20000 10000 100 × (20,000/10,000) = 200%
Return in 2020 – 21 -15000 30000 100 × (-15,000/30,000) = -50%
Absolute Return between 2019 – 21 15000 – 10000 = 5000 10000 100 × (5,000/10,000) = 50%
Simple Annualised Return between 2019 – 21 5000 in two years 10000 100 × [(5000/10,000) × 2]= 25%

CAGR is considered to be the best way to smoothen out the returns. It helps to calculate the annual growth rate on the investment whose value has not been the same over the years and has fluctuated year to year.

CAGR Formula = [(Ending Value / Beginning Value )^ (1 / Number of years) ] – 1

Relative Return

Relative return enables a person to determine the true return he/she had earned from the invested fund over and above the benchmark. It determines how the return of stock performs when it is compared to the benchmark. This can be very useful while making decisions regarding investments. For example, if the stock one is holding achieves a return of 20% while the benchmark index informs that the nifty managed to get a return of 15.58%, then it is considered that the particular stock has achieved a relative return of 4.42%. A stock that seems to fall less than the benchmark is considered as a good performance stock because it manages to contain losses for the investor.

Peer Returns

Let’s say a person invests in the State Bank of India, and the value of the stock increases by 7% in a year. The value of other bank stocks also increases, such as HDFC bank by 9%, ICICI Bank by 6.5%, Punjab National Bank (PNB) by 5% and Banking Index by 6%. This shows that SBI has given a better return than the banking index and, from among its peers, better than PNB but less than HDFC bank and ICICI bank. Peer return helps to select where to make the investment within a particular sector or sub-group of an asset class such as banking stock, as per the above example.

Internal Rate of Return

The internal rate of return is considered to be a metric that is generally used in financial analysis for estimating the profitability of the potential investments. The internal rate of return is considered to be a discounted rate that makes the net present value of all the cash flows zero when it is used in discounted cash flow analysis.

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