How to calculate your return on investment
Determining your return on investment is a very important part of any investment review. Whether you’re investing in savings accounts, stocks, real estate, capital upgrades, or new business ventures, estimating a return on investment will aid you in choosing among investment options.
I don’t simply calculate a straight return on investment. I prefer determining an annualized rate of return that takes into consideration the timing of investments and return, as well as compounding. Most of you are probably familiar with this concept through the term Annual Percentage Yield (APY), compound annual growth rate (CAGR), or internal rate of return (IRR). Let me walk you through the steps on how you can calculate your return on investment in terms of APY:
Step 1. Calculate all the costs associated with an investment.
Ask yourself the following questions about the investment:
- What are the initial upfront costs associated with the investment?
- What are the maintenance costs?
- Are there any fees or taxes associated with the investment?
- What kind of research costs will you incur to properly evaluate (i.e., due diligence) the investment?
- How much of your time will this investment consume? Your time is valuable, so a complicated project could have real opportunity costs.
Basically, don’t forget the hidden costs often associated with investments. Be sure to list out all costs you can think of.
Step 2. Estimate or calculate your returns.
- How much do you expect to gain from the investment?
- When do you expect returns to happen?
Determine how much you expect to gain from the investment. Detail specifically all the individual returns you expect to receive from the investment.
Since returns from investments are often uncertain, you might also want to jot down what you think the probability of each return occurring when you thought they would. Be sure to also specify when these returns will occur and for how long. This will be important for the next step.
Step 3. Establish a timeline for costs and returns.
Draw a simple timeline or just list in chronological order all the costs and returns you discovered in steps 1 and 2. Costs should be listed as negative dollars and returns as positive dollars.
For example:
- 1/1/2006 Initial investment cost: - $100,000
- 9/21/2006 Sell investment: $120,000
Step 4. Calculate annualized return of investment or APY.
This is the meat of the process and the most challenging step of calculating the return on an investment. Let me explain it using a simple example that we started above.
Let’s assume you made an investment on January 1, 2006. That investment cost you $100,000 including fees. Today, September 21, 2006, you decide to sell that investment and you receive $120,000 after all expenses.
Now we want to find the APY of this investment so we can compare it to other investments or even your savings account rate. In finance, this is often called calculating your internal rate of return. Technically this process involves determining a discount rate at which the present value of a series of investments is equal to the present value of the returns on those investments. (Ah, this brings back memories of economics in graduate school.) Thankfully, you don’t have to fully understand the process of how this is calculated in order to use it.
For a simple situation like the example above:
APY or IRR = (Final return/Initial investment)^(365/days) - 1
In English, this means that APY equals the final dollar amount divided by the initial investment (positive number for this equation) raised to 365 divided by the number of days the investment took to complete. Then you subtract one from the number you just calculated and multiple by 100 to get your percent APY.
Too bad most investments are not this simple. You often have to pay additional capital in throughout the investment project (e.g., quarterly taxes) and your returns often come in periodically (e.g., monthly) and often with a final lump sum payout (e.g., you sell your investment to someone and get paid).
Modern spreadsheet software includes a great function to automagically find the internal rate of return (IRR), which is the same as APY. Microsoft Excel (MSFT), Open Office (SUN), and Google Spreadsheets (GOOG) include the flexible XIRR function that can take a list of investments and returns and the corresponding dates of those events and calculate the APY for that investment. This is a powerful and very useful function that I recommend everyone learn how to use and understand. The XIRR function is very flexible. You can you it for very simple investments like the example above or much more complex situations that include payments that occur regularly or even irregularly.
Let me show you a two examples:
Example #1 - Monthly returns
Example #2 - Yearly returns
View the examples using Google Spreadsheets.
View the examples using Excel spreadsheet: Annualized rate of return.xls. This spreadsheet includes the simple example from earlier in the post as well.
Notice how the return in Example #1 is much higher than that of Example #2 even though the payment amounts and total profit are the same. The key difference is the timing of the payments. Because the returns in Example #1 come monthly, the annualized rate of return or APY is much higher. In Example #2, profit dividends only come in annually. That dramatically reduces the APY. I like using annualized rates of return because they account for the time value of money.
That’s it! Now you know how to properly measure your return on investments. Compare the different annualized rates of returns for your various investment options and then you can select those with the highest rates of return (assuming risk is equal among the alternatives). You can also determine your “real” return by subtracting out the average rate of inflation from the annualized rate of return. This way you can determine if you are actually building wealth with your investments.
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#1
This is excellent. I like to give myself the ability to do constant pro forma analysis. Cell references in Excel facilitate this, allowing me to compute based on the contents of a cell, which I can change, rather than formulize a given percentage.
#2
Ah, very useful indeed, thanks! Our how-to is up as well if you’d like to check it out!!
#3
How do you take account of lucky picks from distorting your return? In my situation, I made a big purchase on September 2006 that went pretty lucky. The stock has gone up 5%. This skewed the annualized return. According to Excel’s XIRR, asof December 31, 2006, I’ve made 18% return on it. Anyone have any insight?
#4
Your calculations are wrong!
IRR is 28% and 3.59% respectively in your examples above!
#5
ML,
I do not see the error with my calculations. Could you share with us how you came up with an IRR of 28% and 3.59% respectively?
#6
Thanks for the very good post about how to calculate rate of return! I wrote my own post about the XIRR spreadsheet function on my own blog, referring my readers to this post. I found the Excel spreadsheet especially useful. I hope that this is OK with you.
#7
pfstock I’m glad you found this post useful. Thanks for the feedback and the linkback.
#8
sir i have done my m.b.a. in marketing and presently i am associated withan fmcg company but i am interested to do some course in finance if u guide me in this relation then it will be great moreover if u could send me some literature in context to finance then i would be verythankful to u my email id is tgupta83@yahoo.co.in
#9
I can’t seem to adapt this to work for me. I buy and sell stocks frequently. I also deposit and withdraw money from the account frequently. What would be the best way to calculate how my entire portfolio is doing?
#10
Hi George, the XIRR function is not recognized in Google spreadsheets - is there something I’m missing?
Great article - thanks!
#11
Jonah, the XIRR function is working in my example Google Spreadsheet. Be sure the dates column for the XIRR function are properly formatted dates in Google Spreadsheets. Sometime they can get converted to standard text. I hope that helps.
#12
Hi George,
What method would you use to compare the $100,000 initial investment in your example to investing that money in a high yield savings account with 5% compounded interest? I’m trying to find the correlation between the final answer APY/XIRR in your example and the 5% compounded interest number - basically to answer the question - how does this investment compare to a simple bank account at x% compounded interest?
Thanks in advance!
#13
a humble request to all the Financial wizards……can somebody tell me the difference between Return ON investment and Return OF investment ???
Thnx & regards,
Rajesh Pawar
#14
Thanks for the info about to calculate your return on investment - Fat Pitch Financials!
#15
In calculating the IRR% using MONTHLY cash streams does one multiply the formula by 12 irrespective of whether the cashflow is say 12 months or 48 months ie. you’re using the figure 12 as a common factor to convert years to months?
#16
Could somebody please help me know how to figure this hypothetical situation:
I invest $1000 per month in a mutual fund. After 12 months, it is worth (with growth & dividends) $15000. What was my rate of return, assuming $1000 per month meant that my total investment is $12000? I could figure it easily as 25% if I invested $12K one time, and one year later it was worth $15K, but I do not know how to figure it since I invested $1K twelve different times - monthly.
Thank you.
#17
How do you take into account the fact that you make withdrawals during the year. Example: Balance Jan 1 is $100,000; take out $1000/month each month and withdraw $20,000 on Aug 15; balance Dec 31 is $103,000. What is that real return on you investment for that year.
Thanks Bob
#18
Nice and Simple article. Examples are excellent.
#19
Hi,
I would like to know , how to calculate monthly gai/loss of NAV in percentage.
Thanks,
Sanjay