Measuring Investment Returns

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Welcome to this lesson on Measuring Investment Returns

When we are investing in a security, we focus a lot of Returns.

What is Return?

Return is

the comparison of the inflow

and outflow

and therefore the benefit to the investor from making the investment.

As we know, returns can be positive or negative.

Measuring Returns

Return can be measured in absolute rupee terms or as a rate of return.

Absolute Terms

Example for Absolute terms: The investment gave a profit of Rs. 1000

Rate of Return

The rate of return is usually measured in percent terms.

This means equalizing the amount invested to Rs. 100.

This enables comparison of return across investments even if the amount invested is different.

Example for Rate of Returns: The investment gave a profit of 10%

Now one more term

Absolute Returns

Do not get confused between Absolute Returns and Absolute Terms (discussed above)

Absolute Returns

The absolute return on an investment is computed as

((End Value - Beginning value) / beginning value) x 100

Absolute return does not take the holding period of the investment into consideration.

So, it is not an appropriate measure for comparing the performance of investments made for different periods of time.

For example, it is not an effective measurement tool for computing SIP returns.

Perhaps it is a good tool for use on lumpsum investment.

Annualized return

Annualized return is a standardized measure of return on investments in which the return is computed as percent per annum.

This enables easy comparison of investments across time periods.

Total Return

Total return is the return computed by comparing all forms of return, income and capital appreciation, earned on the investment with the principal amount.

Have you heard of the word called Total Returns oflate?

Investors in mutual funds will understand that we are now moving towards total returns concept.

So, Mutual Fund returns now show returns of not just the profit / losses that come from sale proceeds...

but also include the dividends that got accrued.

So, this method is a fairer way of computing and measuring returns.

An investment may be a growth-oriented or income-oriented investment.

We already have discuss about the differences, advantages and disadvantages of this in our earlier sessions.

For example, in the lesson on Retirement planning,

we said that ..

In the working years, we need to be on Growth orientation

and post-retirement, we need to switch to Income-orientation.

Now let us go to the most obvious term that everyone will be looking for...

Compounded Returns

Compound return is earned ..

when the interest earned in one period is ..

added back to the principal amount

to generate a new principal

on which interest is computed for the next period.

As a result, interest is reinvested in the asset

.. so that interest is earned on interest.

The compounded return will depend upon the frequency of compounding.

Higher the frequency higher the compounded returns.

So, the question you should ask is:

How frequently is the investment compounding.

Future Value

Now let us go to the next topic: Future Value

It is obvious that as Investment Advisers or even as investors, we need to compute the future value of our investment.

The future value of an investment can be easily computed in EXCEL using the FV function.

The value associated with the same sum of money received at various points on the time line is known as time value.

Example:

We must have seen this in insurance policy presentations where they show what value we get at different points of time.

Calculating cash flow

Since money has time value, it is not possible to compare cash flows received in different time periods.

There are two popular ways of calculations:

1. Discounted Rate

2. Compounded Rate

Discounted Rate

Future inflows are discounted by a relevant rate to reach their present value; this rate is known as the discount rate.

Example

For instance, an investor might have Rs 10,000 to invest and must receive at least a 7 percent return over the next 5 years in order to meet his goal.

This 7 percent rate would be considered his discount rate.

It’s the amount that the investor requires in order to make the investment.

The discount rate is most often used in computing present and future values of annuities.

For example, an investor can use this rate to compute what his investment will be worth in the future.

If he puts in Rs10,000 today, it will be worth about Rs 26,000 in 10 years with a 10 percent interest rate.

Conversely, an investor can use this rate to calculate the amount of money he will need to invest today in order to meet a future investment goal.

If an investor wants to have Rs 30,000 in five years and assumes he can get an interest rate of 5 percent, he will have to invest about Rs 23,500 today.

Compound Rate

Present inflows are increased at a relevant rate to reach their future values: this rate is known as the compound rate.

The higher the discount rate, the lower the present value of future cash flows.

A higher rate means that investors have to forego more returns by opting for future cash flows.

Annuity

An annuity is a sum of money paid at regular periods, such as monthly, quarterly, annually.

Annuities can be of two types

(1) Fixed annuity and (2) Flexible annuity.

CAGR

The compounded annual growth rate (CAGR) of an investment

is the underlying compound interest rate that equates the end value of the investment with its beginning value.

Remember earlier, I said: We need to compound... this is the first thing

Then we need to compound faster..

i.e rate or pace of compounding

Or How quickly it compounds

CAGR tells this

There is a simple formula for this

CAGR = ( End Value / Beginning Value) ^ (1/n) – 1.

Do not get scared looking at the formula.

We have EXCEL :)

The XIRR function in Excel can be used to calculate CAGR.

CAGR is the accepted standard measure of return on investment in financial markets

CAGR cannot be used in case of returns that involve periods of less than one year.

The CAGR of an investment does not represent the actual rate at which the investment grew each year of the investment period.

It is a smoothened average annual rate.

IRR

Now let us put attention to IRR

IRR = Internal rate of return (IRR)

IRR is a discount rate method that makes the net present value (NPV) of all cash flows from a particular project equal to zero.

IRR is the inherent rate at which all the cash outflows compound to become equal to the cash inflows from an investment.

IRR is used to evaluate investments.

If the IRR is greater than or equal to a minimum hurdle rate, the investment is considered to be financially worthwhile.

Now what is this Net Present Value ?

The net present value of a series of cash flows can be ..

calculated as the difference between the present value of the cash outflow and the sum of the present values of the inflows that accrue over a period of time.

A positive NPV implies that the investment is worthwhile.

A negative NPV indicates that the investment should be avoided.

Example

Assume that there is an interesting investing offer for you.

Invest Rs 2,000 now, receive 3 yearly payments of Rs100 each, plus Rs2,500 in the 3rd year.

You need to determine if this is really an interesting offer for you.

We hear this type of schemes and offers every now and then.. right?

IRR is can be used to judge this.

Let us try 10% interest.

Now: PV = - Rs 2,000

Year 1: PV = Rs 100 / 1.10 = Rs 90.91

Year 2: PV = Rs 100 / 1.10 ^ 2 = Rs 82.64

Year 3: PV = Rs 100 / 1.10 ^3 = Rs 75.13

Year 3 (final payment): PV = Rs 2,500 / 1.10 ^3 = Rs 1,878.29

Adding those up gets:

NPV = -Rs 2,000 + Rs 90.91 + Rs 82.64 + Rs 75.13 + Rs 1,878.29 = Rs 126.97

To get the exact IRR, we need to get the answer as 0

So, in the above example, its IRR is not at 10%

It is more than 10%

So we should try computing with 12%

Lets see what happens when we compute at 12%

Now: PV = - Rs 2,000

Year 1: PV = Rs 100 / 1.12 = Rs 89.29

Year 2: PV = Rs 100 / 1.12 ^ 2 = Rs 79.72

Year 3: PV = Rs 100 / 1.12 ^ 3 = Rs 71.18

Year 3 (final payment): PV = Rs 2,500 / 1.12 ^ 3 = Rs 1,779.45

Adding those up gets:

NPV = -Rs 2,000 + Rs 89.29 + Rs 79.72 + Rs 71.18 + Rs 1,779.45 = Rs 19.64

Here we got the answer as Rs 19.64

But we can get more closer to 0.

When we take at 12.4%, we get something like Rs. -0.94

When we compute at 12.4%, we get it as 0.

Let us stop there and say the Internal Rate of Return is 12.4%

In a way it is saying "this investment could earn 12.4%" (assuming it all goes according to plan!).

Based on this, you determine if the investment is a good one or not.

We need not have to do the computation actually.

Excel gives u the answer as 12.4%

I just explained you so u can understand the computation.

More jargon

Holding period return is the return earned on an investment during a specific period when it was bought and held by the investor.

The nominal rate of return is adjusted for the effects of inflation to get the real rate of return.

Tax-adjusted return is the return earned after taxes have been paid by the investor.

Risk adjusted returns relates the excess return generated in an investment to the risk assumed.

Investors will seek a higher risk adjusted return from their investment.

This is the ultimate objective

Questions

1. Easy comparison of return on investments across time periods is done by _____

2. Give example of growth oriented investment and income oriented investment?

3. Is simple interest or compounded interest will increase value of investment fast? why?

4. Which function will help in EXCEL to calculate CAGR?

5. If an investor wants to have Rs 1,00,000 in Ten years and assumes he can get an interest rate of 10%, how much he vl have to invest today?

6. What should be the priority in investment? Return or Risk?

Related Topics

Introduction to Indian Financial Markets Asset Allocation and Investment Strategy Investment Adviser and Regulatory Environment Investment Products Investment Risk and its Measurement

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