Every investor invests in order to earn a good rate of return on their capital invested. In the stock market, return is in the form of dividends and/or capital appreciation. Traditional risk free investments do not offer any capital appreciation.
By calculating your rate of return, you will be in a position to measure the growth or decline of your investment. You will also be able to evaluate your own performance in comparison to other investments and the market.
Now the question is how to calculate the rate of return or ROR if you are investing in stocks or planning to invest in the stock market.
How to calculate ROR or rate of return
In stock market, your total income has two components;
- Income, known as dividend.
- Capital gain or loss.
The formula to calculate rate of return in stock market is as follows:
Rate of return or ROR = ((Stock Selling price – Buying price) + dividend ) / purchase price
Immagine you have purchased stock of company A at Rs 1,000 including commission paid to broker and sold it at Rs 1,200 (net proceeds received after deducting commission).
During the year you also have incurred dividends as a stock owner.
To calculate ROR, you need to first find out your capital gain and dividend received.
Which is in out case calculated below:
Capital gain = 1200 – 1000 = 200
Dividend received = 50
Therefore, rate of return = ( capital gain + dividend ) / purchase price = (200+50) / 1000 = 25%
Remember, to know the actual ROR you need to understand the impact of time value of money for the time period you have owned the stock.
For example, if you are holding the stock for a period of 5 years with 15% return every year, you need to calculate the present value of the return by taking the time value of money into account. Then you need to compare with any rate of return with other investment options to understand how your stock has performed.
Inflation also has an impact on your ROR. In case of high inflation, your ROR will come down as it will have the impact of inflation. Therefore, if your ROR is 25% per year and inflation is 5% for the same year, then the actual ROR is only 20% per year, which is 25% minus 5%.
Similarly, you also have to take taxes into account as it will reduce your rate of return. Which means while comparing you need to take after tax ROR into account.
If you are holding stocks for long term, in order to find out your rate of return or ROR, in place of stock selling price you have to take market price. In which case, you can re-write the formula as follows:
ROR = ((Stock Market price – Buying price) + dividend ) / purchase price