Calculating Rates of Return
Companies and investors assume risks to earn investment returns commensurate with the risks. A return (or rate of return) is the amount received on investment from holding that investment for a period of time to the amount of the initial investment. Of course, not all returns end up as financial gains. The owner of a financial investment or asset may experience a loss over a given period. Returns reflect any change in market prices for the investment and interest or dividends received from the investment and usually are expressed as a percentage of the beginning market price of the investment. At the most superficial level, a return is calculated as the change in market price, plus any cash payments received in the form of dividends or interest, divided by the beginning price of the security. For example, the rate of return, also called the holding period return (HPR) for common stock over one period is:
R = (Pt – Pt-1) +D
R = rate of return (holding period return)
Pt =common stock price at the end of the period
t = time period
Pt−1 = stock price at the beginning of the period
Dt = cash dividend at the end of that time period
For example: Assume that an investor buys a share of common stock for $20 exactly one year ago and the stock price rises to $22. During the period, the company pays a $2 cash dividend per share. What is the one-year rate of return for this stock?
• Pt (current stock price) =$22
• Pt−1 (previous stock price) = $20
• Dt (cash dividend) = $2
R = ($22- $20) + 2 = = 0.2 oe 20%
The time period (t) can be any length of time. In this case, t represents the holding period for the common stock of one year. Thus, the rate of return on common stock is 20%.