Rate of Return

Lesson 1 Calculating the Rate of Return

on Stocks and Bonds

Calculating Rate of Return

Aim: How do we know how much money

we’ve earned from an investment?

Do Now: What are the two ways that one can

profit from owning a share of stock? A bond?

Do Now answer: 1. Share of stock: The owner may receive

periodic dividends as well as sell the share for more than he or she bought it for

2. Bond: The owner is entitled to periodic (usually twice per year) interest and (if interest rates fall), sell it during its term for a potential profit

Calculating Rate of Return

Scenario: I.N. Vestor is the top plastic surgeon in Tennessee. He has $10,000 to invest at this time. He is considering investing in Frizzle Inc. What factors will influence his investment on Frizzle, Inc.?

1. He wants to make money (generate a return) on his investment.

2. He wants to keep his money safe.

Calculating Rate of Return

Calculating Rate of Return

Rate of Return: the percentage either gained or lost on the original investment, usually measured over a year.

To make an educated investment decision, I.N. Vestor can research the return that the investment has generated in the past. (known as historical return)

Calculating Rate of Return

Historical Return (Realized Return): Historical measure of what an investor has earned based on actual historical cash flows during a specific holding period.

Components of Stock’s Realized Return

Dividends: A portion of a company’s earnings distributed to its stockholders. It is not obligated to pay a dividend and in difficult times may reduce or eliminate the dividend.

Capital gain: Profit that is realized when the security is sold and the selling price (P1) is greater than the purchase price (P0). If the price of the stock drops during the period, a capital loss is realized.

Capital Gain (Loss) = P1 – P0

– A capital gain is realized when the result is positive.– A capital loss will is realized when the result is negative.

Calculating Rate of Return

Holding Period: The time frame starting when the initial investment in the stock/bond begins and ending on the day the stock/bond is sold. It can be any length of time.

Historical/Realized Return

Example: I.N. Vestor purchased Stock ABC one year ago for $33. The company paid a dividend of $1.75 and now has a price of $37.25. What realized (historical) return did he earn over the one-year period?

Realized Return = Dividend + (P1 – P0) P0

Historical/Realized Return

Realized return =

Dividend + (price @ sale - price @ purchase)

price @ purchase

 

On his initial investment of $33, the realized (historical) return is:

$1.75 + ($37.25 - $33) = 18.2%$33

Components of Bond’s Realized Return

Coupon: Periodic payment of interest that the issuer is required to pay at set intervals, (typically semiannually) until maturity.

Components of Bonds’ Realized Return

Capital gain: While the investor can always wait until the bond matures and receive the face value back (meaning no capital gain or loss occurs)…

…if the bond is sold prior to maturity, a capital gain or loss may be realized depending on the bond’s market price at the time of sale.

Historical/Realized Return

Example: I.N. Vestor purchased a new 5% ABC Corp. bond one year ago for $1,000. The company made two interest payments of $25 during the year. With interest rates having fallen over the course of the year, today I.N. sold the bond for $1,015. What realized (historical) return did he earn over the one-year period?

Realized Return = Interest + (P1 – P0) P0

Historical/Realized Return

Realized return =

Interest + (price @ sale - price @ purchase)

price @ purchase

 

On his initial investment of $1,000, the realized (historical) return is:

$50.00 + ($1,015 - $1,000) = 6.5%$1,000

Lesson Summary1. What do we call a return on an investment that

we’ve achieved because we sold out of the investment?

2. What can we say about the holding period of an investment?

3. What are the two components of a stock’s realized return?

4. What are the two components of a bond’s realized return?

5. How do we know how much money we’ve earned from an investment?

Web Challenge #1Q: Can realized returns be difficult to evaluate? A: Yes, because the holding period can vary so much.

If an investor said he realized a 100% return, you might be impressed. If he said it required holding the investment 10 years, you’d be less impressed.

Challenge: Visit http://screener.finance.yahoo.com/bonds.html? Find three corporate bonds that are trading for much higher than face value. Click on them to find when they were issued. Document the amount of the capital gain that can be achieved by selling them now, as well as how many years it took the bonds to get to today’s price.

Web Challenge #2Challenge: Companies that pay high dividends (compared to their stock price) are safer than normal stocks for investors because dividends are a component of the return that never has to be given back!

Research three corporations that have high dividend yields (over 4%). Identify the dividend amount as well as how much their share prices have gone up or down in the last 12 months. Calculate the total return as well as which component contributed more to the total return.

Web Challenge #3Challenge: A stock’s dividend can also be viewed as a cushion against losses. To illustrate this idea, research three corporations with a high dividend yield (again, in excess of 4%) whose stock prices have fallen over the course of the last year. Calculate the realized return as if they were bought a year ago and sold today. Determine whether the dividend was enough to make the realized return positive.