Average rate of return definition
/What is the Average Rate of Return?
The average rate of return measures the annual return that an investment is expected to generate over its useful life, expressed as a percentage of the original investment or average investment. It is calculated by dividing average annual cash flow or accounting profit by the investment amount. Investors and managers use it to compare investment alternatives, screen projects, and assess whether a return is adequate. The measure is simple to understand, but it has limitations. It does not fully consider the timing of cash flows, risk differences, or the time value of money.
How to Calculate the Average Rate of Return
The average rate of return is calculated by aggregating all expected cash flows and dividing by the number of years that the investment is expected to last. It can also be calculated as the sum of the annual rates of return on an investment, divided by the number of years over which those returns are expected to occur.
Example of the Average Rate of Return
For example, an investment in real estate is expected to generate returns of $22,000 in the first year, $32,000 in the second year, and $36,000 in the third year. The average of this amount is $30,000. The initial investment was $300,000, so the average rate of return is 10% (calculated as the $30,000 average return divided by the $300,000 investment).
Problems with the Average Rate of Return
There are several problems with using the average rate of return, which are as follows:
Does not account for the time value of money. The average rate of return does not account for the time value of money. Cash flows in later periods are worth less than cash flows in more recent periods, but this is not included in the measurement.
Does not focus on cash flows. The average rate of return is based on accounting profits, rather than cash flows. Cash flows are a more accurate indicator of the return generated, since accounting profits can be manipulated through accounting chicanery.
Does not account for risk. The average rate of return does not incorporate any consideration of the risk of the underlying investment. This means that you might use the metric to invest in something that has an extremely high risk of loss, while avoiding a slightly lower-yielding investment that has a minimal risk of loss.
Average Rate of Return FAQs
When is the average rate of return most commonly used?
The average rate of return is most commonly used in internal decision-making when businesses want a quick, straightforward evaluation of an investment's profitability based on accounting income. It is often applied in scenarios where simplicity is prioritized over precision, such as initial project screenings. It is also favored when firms rely heavily on financial statements rather than cash flow projections.