Understanding Average Rate of Return (ARR)
The Average Rate of Return (ARR) is a straightforward metric that investors use to assess the profitability of an investment over a period of time. It’s calculated by dividing the net earnings of an investment by the number of years the investment was held, and then dividing that result by the initial acquisition cost of the investment. Despite its simplicity, ARR offers valuable insights.
The Formula
To better understand ARR, here’s the calculation formula:
ARR = (Total Net Earnings / Number of Years) / Initial Acquisition Cost
However, one significant drawback is that this method doesn’t take into account the specific timing of earnings.
Enhanced Example
Let’s break down an enhanced example to illustrate ARR’s utility:
- Initial Investment: $200
- Annual Dividend: $5
- Years Held: 7 years
- Selling Price after 7 years: $270
Step-by-Step Calculation:
-
Calculate Total Net Earnings:
- Annual dividends over 7 years: $5 \* 7 = $35
- Gain from selling: $270 - $200 = $70
- Total Net Earnings: $35 + $70 = $105
-
Calculate Annual Net Earnings:
- Annual Net Earnings: $105 / 7 = $15
-
Calculate Average Rate of Return (ARR):
- ARR: ($15 Annual Net Earnings) / $200 Initial Investment = 0.075 or 7.5%
Thus, the investment yields an Average Rate of Return of 7.5% annually over the 7-year period.
FAQs
Q: What is the major limitation of using ARR?
A: ARR does not account for the timing of earnings, which could be critical in understanding the performance of an investment over time.
Q: How is ARR different from IRR (Internal Rate of Return)?
A: Unlike ARR, IRR considers the timing of cash flows, making it a more accurate measure for evaluating the profitability of investments that have varying returns over time.
Q: Can ARR be used for comparing different types of investments?
A: Yes, ARR provides a simple way to compare the average yearly return of different investments. However, for a more comprehensive analysis, considering other metrics may be beneficial.
Embrace the power of Average Rate of Return to make informed investment decisions and unlock the potential of your portfolio.
Related Terms: Return on Investment, Internal Rate of Return, Net Present Value, Earnings Before Interest and Taxes, Return on Assets.
