The rate of return you get on your investments might often not be your final return. Here’s how to calculate it
Ashish Pai, Business Standard 27/8/2013
It’s a dilemma that many investors might be going through. Your fund says that it earned a return of 15 percent, but you find out that your final returns were actually much lower. The gap between what a fund reports as returns and the what investors finally get are sometimes huge and the difference is largely because of the fact that a fund might calculate returns differently than you.
You should look at a lot of other factors to calculate your final return and that includes adding up dividends or adjusting your tax status in your final return. Let us look at the return calculation of these two most popular investment class: fixed income and equities.
A hang of fixed income
For fixed income instruments, always look at post tax returns as the adjustment for taxes will actually show you how much you really made. Tax is an expense from your return. Here’s how to calculate it. Suppose a bank deposit is currently having an interest of 9 percent for one year. An interest rate of 9 percent appears very attractive. However, the return post taxes turn out to a lot lower. If you are in the highest tax bracket, it is less than 6.20 percent. So take into account not only the absolute return but also its post-tax status.
CALCULATE TRUE RETURNS
For bank FD
Interest earned from banks: 9%
Deduct taxes paid @30%: 2.7%
Arrive at the final return: 6.3%
Post-tax interest earned – 8%
Equivalent pre-tax interest@30% – 12.6%
(PPF is tax-free in hands of investors)
Stock purchase price: Rs 100
Dividend received*: Rs 10
Stock sale price: Rs 120
Total earnings: Rs 20 + 10
Gross returns: 30%
Tax at 10% on capital gains: Rs 2
Net returns: 28%
*@100% of Rs 10 face value
Adjust it for inflation.
Tax adjustment is just one part of finding out the final returns. The other is to adjust it against the rate of inflation. You know that the value of your investment diminishes over time due to inflation. If you adjust this inflation for your investments, you will get a real rate of return.
When an investment is made, you postpone your current consumption for future income. If during the period of investment the price of goods or services rises, you require more money to acquire these. It is, therefore, essential to adjust your total return on investment for inflation. This is known as the real rate of return. To illustrate, suppose you earn interest at 9 percent on your bank deposits. Assume inflation is at 8 per cent. The real return adjusted for inflation is merely one per cent. If inflation is more than nine per cent, the real rate of return turns negative.
Compounding effect: In case of fixed income instruments such as bank fixed deposits, there is quarterly compounding of interest. This improves the effective yield. For example, if you invest in bank fixed deposit at 9%, the effective yield is at 9.30% due to quarterly compounding. Similarly in case, if you invest at 9.50%, then the effective yield is at 9.84%. If you invest at 10%, the effective yield will be near 10.40%.
Impact of liquidity on returns: At times, there can be impact on returns due to liquidity. For example, in case of bank fixed deposits, if they are withdrawn prematurely, then the interest rate applied will be rate applicable for the tenor for which it was maintained prevailing on date of deposit less penalty of 1% for premature withdrawal.
There are some tax-free instruments for which the pre tax returns need to be calculated to make them comparable for decision making. The two popular tax free avenues are Public Provident Fund and Tax free bonds.
Public Provident Fund (PPF): Public Provident Fund is one attractive investment avenue, with high post-tax yield. Currently, it gives a tax-free return of 8.70%. So, pre-tax yield comes to around 12.60% for a person at the highest tax bracket, that is, 30 per cent. In addition, investment up to Rs 1,00,000 per annum qualify for rebate under section 80C of the Income Tax Act.
The minimum and maximum amounts that can be invested in a year are Rs 500 and Rs 100,000 respectively. An account matures in 15 years; however, withdrawal is permitted after completion of the sixth financial year from the initial year of subscription.
Tax-free bonds: This are typically bonds issued by PSU entities such as REC, PFC, IRFC, HUDCO etc. The duration is for 5 to 10 years. The tax free interest rate varies from 7.50% to 8.30%. Accordingly the pre-tax yield can range from 10.87%to 12%. The added advantage of the tax free bonds is that they are listed on the stock exchange and provide moderate liquidity.
A hang of equities
In case of stocks, the returns need to be calculated after adjusting for corporate actions such as Dividend, rights issue etc, if any. Suppose you buy a stock of worth Rs 106 which is cum dividend. After the dividend record date you sell the same at say Rs 100/-. You will receive a dividend income of Rs 6 and there will be short term capital loss of Rs 6%. The simple return from the stock is Nil. However, in case the stock is sold at say Rs 108. Then the total absolute return will be not Rs 3 but Rs 9 including the dividend of Rs 6 paid.
Similarly if you have share on which bonus is received, the cost price needs to be adjusted for the bonus. Suppose the cum bonus cost price is Rs 100 and you receive a bonus of 1:1. Then the cost price after bonus will be Rs 50. If you sell this stock for say Rs 60, then the absolute return on this stock will be 20%.
Time element: An important aspect in calculating returns is the time element. For example, you buy two stocks, say stock A and B, say for Rs 800. Let us assume you sell A after one year for Rs 1,000 and B for Rs 1,040 after two years. Then, the absolute return on A is 25 per cent and on B is 50 per cent. However, considering the holding period, the return is 25 per cent and 15 per cent for A and B, respectively.
Expense adjustment: In case of equities, the investor has to bear charges such as brokerage, Depository charges, Demat account maintenance charges etc. While calculating the returns from this asset class, it is important to reduce the expenses to calculate the return.
Conclusion: Proper understanding and calculation of your return on investment is critical for Investment decision making. It helps in building a robust portfolio and having a proper asset allocation plan. It is important to account for all factors while calculating your returns!
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