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Annualized Rate of Return & Total Return

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

This lesson will introduce total rate of return and annualized rate of return. These concepts will be defined along with a formula for calculating each. Examples will then be used to illustrate each of these types of returns.

Introduction

Jill is a little new to investing in stocks that she picks for herself, and she is definitely having some beginners luck with her picks. She purchased some shares of Speedy Cellular awhile back for $10,000 and the increase in stock price has made her investment worth $12,000 today. She knows that her shares have increased about 20% from doing the math in her head, but she also received a dividend last year of $400. She wonders what the total return % is for this investment including the dividend.

Stock prices change quickly
Stock prices change quickly

Total Rate of Return

What Jill needs to do is calculate the total rate of return for this investment. The total rate of return not only includes the return from asset appreciation, but also adds the return from dividends and interest paid. It forms a basis for comparing many different types of investments since some investments will have only asset appreciation, while others will also have fixed cash payments.

Now let's do Jill's total return. The total rate of return formula is:

(((Current value - original value) + Dividends and interest) / original value) x 100.

Filling in the numbers we have (((12,000 - 10,000) + 400)/10,000) x 100 = (2,400/10,000) x 100 = 0.24 x 100 = 24%. She can now compare 24% with the total return on other stocks over a comparable time period to see if she is doing better or worse than others.

Annualized Rate of Return

Jill also owns several other stocks that she inherited. She has owned one of them for six years. When she inherited the stock it was worth $5,000 and today it is worth $12,000. She knows this is a great return, but wonders how that would break down into a yearly return percentage she can use for comparisons. She also knows her gain isn't all from stock price appreciation since she reinvested the dividends and bought more shares with the money. So what is a good annual % that includes all of the appreciation in her investment? For that we need to calculate the annualized rate of return. The annualized rate of return is the equivalent annual return the investor receives over the time period the investment is held. She will use the annualized rate of return formula. It looks like this:

(Current value /Original value) ^ (1/n) -1

Where n = number of years.

So filling in the numbers she gets (12,000 / 5,000) ^ (1/6) -1

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