The simple rate of return is the amount gained on an investment, expressed as a percentage, before any mitigating costs are included. Calculating it requires taking the profit gained from any investment and dividing it by the cost of the initial investment. It does not take into account the time value of money, which is depreciated by inflationary factors. Another use for the term simple rate of return comes from the world of accounting, where it is used as a measurement on the return of an investment before adjustments are made for any discounted cash flows.
People generally wish to make as much money as possible on the capital which they invest. As a result, accurate measurements for the profitability of specific investments are of paramount importance to investors everywhere. One way to judge investments is a calculation known as the simple rate of return. Although it is extremely basic and does not take into account certain costs that can actually diminish the value of an investment, it is easily calculated and simple enough for most investors to understand.
To calculate the simple rate of return, an investor must divide the profit gained on an investment by the original amount invested. For an example, imagine that an investor has bought $1,000 US Dollars (USD) worth of a particular stock. After a year, the stock has risen in price and the investor sells the shares for $1,200 USD. This means that $200 USD was gained in profit. As a result, dividing the $100 USD profit by the $1,000 USD investment yields a rate of return of 0.20, or 20 percent.
Of course, the simple rate of return fails to take into account some basic truths about the value of money. Inflation within an economy can raise prices over time, meaning that a certain amount of money will decrease in value over time. Other calculations of rate of return can take into account these mitigating costs to get at the true return on an investment.
Accountants also have the need for calculating their own version of the simple rate of return. It is a technique used by business accountants for budgeting and, as is the case with investors, doesn't concern itself with any discounted cash flows. Also known as the unadjusted rate or return, it is calculated by dividing net operating income associated with an investment by the cost of the investment itself. The net operating income is calculated by subtracting expenses associated with an investment from any revenue generated by it.
