How To Find Simple Rate Of Return

How to Find Simple Rate of Return: A Comprehensive Guide

Understanding the simple rate of return is crucial for anyone making investment decisions. Whether you're evaluating a potential stock purchase, analyzing a real estate investment, or assessing the profitability of a business venture, grasping this fundamental concept empowers you to make informed choices. This comprehensive guide will demystify the simple rate of return, providing you with a step-by-step process and practical examples to solidify your understanding.

What is Simple Rate of Return (SRR)?

The simple rate of return (SRR), also known as the accounting rate of return (ARR), is a financial ratio that measures an investment's profitability relative to its initial cost. It's a straightforward method that calculates the average annual return generated by an investment over its lifespan. Unlike more complex methods, SRR doesn't consider the time value of money. This means it doesn't discount future cash flows to their present value. While simpler to calculate, this limitation can affect its accuracy in certain scenarios.

Key Features of SRR:

• Simplicity: Easy to calculate and understand, making it accessible to a broader audience.
• Focus on Average Return: Considers the average annual profit generated over the investment's life.
• Ignores Time Value of Money: Doesn't account for the fact that money received today is worth more than money received in the future.
• Suitable for Preliminary Analysis: Often used as a preliminary screening tool to quickly assess investment viability before delving into more complex calculations.

Calculating Simple Rate of Return: A Step-by-Step Guide

The formula for calculating SRR is remarkably simple:

SRR = (Average Annual Net Income / Initial Investment) * 100%

Let's break down each component:

• Average Annual Net Income: This represents the average annual profit generated by the investment after deducting all expenses. To calculate this, you need the total net income over the investment's lifespan, divided by the number of years.

• Initial Investment: This is the initial outlay of cash required to acquire the investment. This includes all costs associated with the purchase, such as transaction fees, setup costs, etc.

Let's illustrate this with an example:

Example 1: A Simple Investment

Suppose you invest $10,000 in a small business. Over the next five years, the business generates the following net incomes:

• Year 1: $1,500
• Year 2: $2,000
• Year 3: $2,500
• Year 4: $1,800
• Year 5: $2,200

1. Calculate Total Net Income:

Total Net Income = $1,500 + $2,000 + $2,500 + $1,800 + $2,200 = $10,000

2. Calculate Average Annual Net Income:

Average Annual Net Income = $10,000 / 5 years = $2,000

3. Calculate Simple Rate of Return:

SRR = ($2,000 / $10,000) * 100% = 20%

Therefore, the simple rate of return on this investment is 20%.

Applying SRR in Different Investment Scenarios

The versatility of SRR makes it applicable to a wide array of investment decisions:

1. Stocks:

While SRR doesn't capture the complexities of stock valuation, it can still provide a basic understanding of a company's profitability relative to its stock price. You would calculate the average annual earnings per share and compare it to the initial investment per share.

2. Real Estate:

SRR can be used to assess the profitability of rental properties. The average annual net rental income (after deducting all expenses, including mortgage payments, taxes, and maintenance) is compared to the initial investment (purchase price + closing costs).

3. Business Ventures:

When evaluating a new business venture, projected net incomes are used to calculate the expected SRR. This helps in assessing the viability and potential return on investment before committing resources.

4. Bonds:

For bonds, the SRR would be the annual coupon payment divided by the bond's initial purchase price. This provides a basic return measure, but it doesn't consider potential capital gains or losses upon maturity.

Limitations of Simple Rate of Return

While SRR offers simplicity, it has significant limitations:

• Ignoring the Time Value of Money: This is perhaps the most critical limitation. Receiving $1,000 today is worth more than receiving $1,000 five years from now due to inflation and potential investment opportunities. SRR fails to account for this crucial aspect of finance.

• Ignoring the Project's Life: SRR treats all projects with equal lifespan. A shorter-lived project with a high SRR might be less desirable than a longer-lived project with a slightly lower SRR.

• Arbitrary Cut-off Rate: The acceptance or rejection of a project depends on a pre-determined cut-off rate. This cut-off rate is often arbitrary and may not accurately reflect the investment opportunity cost.

Alternatives to Simple Rate of Return

Due to the limitations of SRR, more sophisticated methods are often preferred:

• Net Present Value (NPV): NPV considers the time value of money by discounting future cash flows back to their present value. A positive NPV indicates a profitable investment.

• Internal Rate of Return (IRR): IRR calculates the discount rate that makes the NPV of an investment equal to zero. A higher IRR signifies a more attractive investment.

• Payback Period: This method focuses on the time it takes for an investment to recover its initial cost. It's a simple measure but doesn't consider returns beyond the payback period.

When to Use Simple Rate of Return

Despite its limitations, SRR can be a valuable tool in certain situations:

• Preliminary Screening: SRR can be used as a quick screening tool to eliminate clearly unattractive investment options before more in-depth analysis using NPV or IRR.

• Simple Comparisons: When comparing investments with similar lifespans and risk profiles, SRR can provide a straightforward comparison of their average returns.

• Educational Purposes: SRR serves as a valuable introductory concept to investment appraisal, paving the way for understanding more complex methods.

Conclusion: Understanding SRR's Role in Investment Decisions

The simple rate of return offers a simplified approach to evaluating investment profitability. While it lacks the sophistication of methods like NPV and IRR, its ease of calculation and understanding makes it a useful tool for preliminary analysis and basic comparisons, particularly for those new to the world of finance. However, it's crucial to understand its limitations and to rely on more comprehensive methods for making critical investment decisions, especially when dealing with projects of varying lifespans or those requiring consideration of the time value of money. By understanding both the strengths and weaknesses of SRR, you can make more informed investment choices and optimize your financial strategy. Remember to always conduct thorough research and seek professional financial advice when making significant investment decisions.