Beginners often forget to include additional returns like dividends or interest in the calculation of Return on Investment or ROI. This article aims at giving you a complete understanding and calculation methodology of total returns for betting reporting accuracy
What is Total Return?
Total return is the returns (profit or loss) an investor receives when all distributions are reinvested. Total return is the true rate of return of an investment over an evaluation period. It allows you to see the complete picture of your investment i.e. how well (or poorly) an investment is actually doing.
There are two components to the calculation of total returns –
- Distributions received by the investor
- Reinvestment of the distributions
Distributions received by the investor
As an investor, you are entitled to distributions on your asset. This asset can be a stock, mutual fund, bond or real estate. These distributions are in different forms like –
- Interest (debt and fixed deposit products)
- Capital gains (stocks, mutual funds and real estate)
- Dividends (stocks) etc.
Now, capital gains is the distribution we generally associate with a stock or mutual fund (atleast in India). However it will be wrong to ignore the other distributions that investors receive like dividends. The dividends add up to the returns which needs to be factored into your calculation of total returns.
Let me illustrate with a small example.
You bought the stock of Infosys Limited on 1-Jan-2017 at ₹800. You held it for an year and then sold it for ₹900.
Assuming there were no brokerage involved, what was your return on investment?
The straight answer to this question is ₹100 (i.e. ₹900 minus ₹800) which translates to an annualized return of 12.5% i.e. ₹100 divided by ₹800
However, your stock price returns calculation has ignored the ₹32 dividend that Infosys Limited paid out during this period.
This ₹32 has to be added to your price returns which will boost up your annualized return from this buy-sale transaction. Thus, you made not ₹100 but you made ₹132 in returns from your investment.
Thus, your total return is 16.5% i.e. ₹132 divided by ₹800 — and not 12.5%
In effect, the dividend portion has added an additional 32% in your profits from your investment giving you a higher ROI.
Reinvestment of the distributions
For the purpose of calculating total returns, we shall be reinvesting of dividends or other distributions you receive.
This is important because dividend yields in India have varied between 1.2% to 3.5% over the last 15 years. It is safe to assume a long-term average of 2% dividend yield. And with reinvesting, this 2% can propel your returns much higher when the compounding effect kicks in.
This can be illustrated in an article by David Brett which was published on Schroders. The article explains how dividend reinvestment has affected returns from the stock markets over the last 25 years.
The article calculated how $1,000 invested in January 1993 in the MSCI World Index would have produced a return of $3,231 by March 2018. This was at a annual growth rate of 5.9% and excluded dividends. Once we add dividends received and reinvest the dividends back into the MSCI World Index, the returns improve to $6,416 representing an annual growth rate of 8.3%. That’s twice the money you will have if you had not reinvested your dividends.
Let’s go back to our original example.
Now, we had received the ₹32 dividend on 1-Jul-2017 and the price of the Infosys share on that day was ₹864. In this case, the dividend of ₹32 would have been applied back into buying some portion of the Infosys stock at ₹864 per share.
In reality ₹32 is not enough money to buy one Infosys share, however it means this equals a notional value of 0.037 shares of Infosys.
Thus, starting 1-Jul-2017, you hold 1.037 shares of Infosys.
So, when we calculate our annual returns on 1-Jan-2018, we find –
- 1-Jan-2017 = 1 share at ₹800
- 1-Jul-2017 = 1.037 share at ₹876
- 1-Jan-2018 = 1.037 share at ₹900
Final value on 1-Jan-2018 = ₹933.3
Total returns = 16.667%
Notice, that the reinvesting of dividend has added an extra 0.167% to our returns (we had earlier calculated it as 16.5%)
A related calculation metric you might want to learn more about is XIRR and CAGR. Here are some articles which will be of interest to you:
How to calculate total returns?
While calculating total returns, one has to remember to break the entire series of events to capture the correct values towards this calculation. In essence, the total returns is nothing but a summation of your dividend returns and the capital gain returns.
Let’s take an example.
You have an investment in Hindalco Industries and you want to calculate the total returns of your investment there.
The events in the last two years related to the Hindalco stock are :
- 01-Jan-2017 — Purchase of stock at ₹200
- 01-Jul-2017 — Received dividend of ₹10 (share price on that day was ₹190)
- 01-Dec-2017 — 2:1 Stock Split
- 01-Apr-2018 — Received dividend of ₹5 (share price on that day was ₹115)
- 01-Jan-2019 — Sale of stock at ₹98
Total Returns Calculations Methodology
The worst mistake one can make is to calculate the returns using the pre-split purchase price and the post-split sales price.
The second mistake is to ignore the stock split and the dividend.
We need to look at three things here –
- Adjust the share (units) prices across all events to the post-split prices
- Add dividend to the returns with reinvestment
- Apply the stock split
Step 1 (01-Jan-2017)
You have 1 share of ₹200
Step 2 (01-Jul-2017)
You received a dividend of ₹10 on a day when the share price of the stock was ₹190. You need to reinvest the dividend in the Hindalco stock which will yield you an additional 0.052 (notional) shares (i.e. ₹10 divided by ₹190). Your shares are effectively totalling 1.052 now.
Step 3 (01-Dec-2017)
A 2:1 stock split, doubles your shares from 1.052 to 2.104 shares
Step 4 (01-Apr-2018)
A second dividend of ₹5 was received and the share price on that day was ₹115. This will yield you an additional 0.044 shares to add over the 2.104 shares you already hold. This takes the total to 2.148 shares.
Step 5 (01-Jan-2019)
A total of 2.148 shares is sold at ₹98 which gives you a total of ₹210.576
Step 6 (CALCULATE RETURN ON INVESTMENT)
We calculate the total return % using the formula –
- Total Return % = [ [ (Sale Price / Purchase Price) ^ (1 / n) ] -1 ] * 100
- = [ [ (210.576 / 200) ^ (1 / 2) ] – 1 ] * 100
- Or, [ [ (210.576 / 200) ^ (1 / 2) ] – 1 ] * 100
- = [ 1.0261 – 1 ] * 100
- Total Return % = 2.61%
As we see from the above example, the annualized total return rate, after factoring the stock splits and dividends, is 2.61%.
If we had ignored the dividends, the annualized total returns rate would have been minus 1.00%
To conclude – trusting the stock chart or the price points between two dates is not a smart move. Some investments which might look like a flop might actually have been really smart moves.
Take the example of Ingersoll Rand India.
The company’s share price was ₹610 in Feb 2018 and about the same in Feb 2019.
While the stock price might show it as 0%, you have missed out on a huge special dividend of ₹202 per equity share that the company paid out in Jun 2018.
The dividend is money in the hands of the shareholder and hence needs to be accounted for in the calculation of the total return.