Now, everything in the stocks market boils down to one thing.
Or in other words, generating a reasonable rate of return!
Return on investment or ROI in short is a performance measure used to evaluate the returns of an investment.
The ROI is generally expressed as a percentage or ratio and provides investors with a way to evaluate and compare assets or financial instruments.
The first and most basic method to calculate return on investment is:
The other popular method amongst investors to calculate return on investment is:
However, when it comes to calculating ROI on a stocks investment, the formula gets slightly more complicated.
This is due to the fact that the formula tries to capture the value of money over time.
There are several different formulas to calculate the ROI on your shares, depending on the nature of your investments. We will cover the most popular ones below.
Total returns measure the overall profit earned from all sources including dividends, interests and other capital gains over a set period of time. Generally, total returns are expressed in a form of percentages.
Calculating your Total Returns is simple, but remember to include all metrics where applicable (e.g. dividends).
The formula goes as follows:
Now, let’s talk examples.
Let’s say you bought a Stock for $8,200 and now it is worth $9,300, making you a beautiful $1,100.
Let’s also assume that you received dividends throughout this time with a total value of $400.
Now, let’s calculate the total returns on your investments.
Firstly, we will subtract the total value of the stock at the start of the year from the value at the end.
In our case, the stock was worth $8,200 at the start and $9,300 at the end which means that the stock gained $1,100 in value. This is also called an unrealised gain.
Next, Add any dividends you received throughout the year to the unrealised gain to find your net gain for the year.
In our case, you had an unrealised gain of $1,100 and received $400 in dividends and therefore your net gain for the year was $1,500.
Lastly, divide the net gain or loss by the total value of the stock at the start of the year to calculate the return on the stock.
In our case, the stock was worth $8,200 at the start of the year and you have a net gain of $1,500, you have $1,500 / $8,200 = 0.183. Multiply this by 100 to convert to a percentage. The return on the stock is 18.3 percent.
For the maths lovers out there, this is what the calculations would look like.
Simple returns are super similar to total returns however, they are generally used to calculate returns on investments after they have been sold. Generally, simple returns are expressed in a form of percentages.
You can calculate Simple Returns using the following formula:
Let’s talk examples again.
Say you bought a stock for $2,000 and paid a $20 commission. Your cost basis would be $2,020.
Now, let’s say you are ready to sell your shares for $3,000 (with a $20 commission again).
Your net proceeds would therefore be $2,980.
For the sake of this example, let’s also assume that your dividends were $150.
This is how you would calculate your Simple Returns.
In our example, your simple return would be 0.54 or 54%.
Pretty simple, right?
The Compound Annual Growth Rate (CAGR) measures the value of money in your investment over a long period of time (more than 1 year).
Calculating the CAGR is a little more complex than either of our previously mentioned methods.
The formula goes as follows:
As you’ve probably noticed, we love an example and we wouldn’t leave you without one for the CAGR method.
So, let’s say you are an investor looking to buy 250 shares of a stock that is on the market for $60 per share. Therefore, your initial investment (and initial value) is $15,000. You are looking to leave it untouched for at least 5 years.
Now, to calculate the compound annual growth rate, you will need the ending balance, the starting balance, and the time period, in our case, the number of years.
The ending value of the investment, divided by the beginning value, is raised to the power of the reciprocal of the time duration of the investment, which in this case, is 5 years.
For the sake of this example, we will say that the stock has risen to $110 per share in the past 5 years. This means that its worth is now $27,500.
($27,500 / $15,000 ^ ¼ ) CHANGE TO 5
Next we subtract 1, and multiply by 100% to see its value as a percentage:
($27,500 / $15,000 ^ ¼ )- 1 = 0.2033
0.2033 x 100% = 20,33%
The Compound Annual Growth Rate for your stock is 20,33%.
And that’s it!
These are the three main methods used by investors to calculate their profits (or losses).
If you haven’t invested in stocks yet, just keep these in the back of your mind for now and you can always come back to them later.
You might end up choosing one of the methods to calculate your returns or you might end up using all three of them.
Ultimately, it all comes down to the type of trader you are and how you choose to invest.
Oh, and if you don’t want to do the calculations yourself, you can always use the stocks profit calculator here.
See you in the next lesson!