Understanding Returns
Dollar Returns
The dollar return of a security is the difference between the initial and ending value.
Finding the dollar return for securities that trade in open markets is a matter of finding the difference in price from year to year. For example, consider in which a $100 security earns a stated return of 5% per year. At the end of year one, it is worth $105, which is five more than $100 (its value at the beginning of year one), so the dollar return is $5. The capital value at the end of year two is $110.25, which is 5.25 more than at the end of year one and 10.25 more than at the beginning of year one. Therefore, the dollar gain is 10.25. This continues for each successive year.
| Year 1 | Year 2 | Year 3 | Year 4 | |
|---|---|---|---|---|
| Rate of Return | 5% | 5% | 5% | 5% |
| Geometric Average at End of Year | 5% | 5% | 5% | 5% |
| Capital at End of Year | $105.00 | $110.25 | $115.76 | $121.55 |
| Dollar Profit/(Loss) | $5.00 | $10.25 | $15.76 | $21.55 |
| Compound Yield | 5% | — | — | 5.4% |
Dollar Profit/(Loss) The dollar return is the difference in value from year to year, plus the previous dollar return.
The dollar return does not consider things like the time value of money or how much return is earned per year; it is simply the difference in nominal values. This means that dollar returns can provide an incomplete picture if used incorrectly.
For example, suppose an investor has two investment options, both promising a dollar return of $1,000,000. They cannot tell which option is better without knowing additional details, such as the risk or how long it will take to realize the returns. If the first option has a $1,000,000 return over two years and the other has a $1,000,000 return over 10 years, the first option is clearly more attractive.
Dollar returns are valuable for comparing the nominal differences in investments. If two investments have similar profiles (risk, duration, etc.), then dollar returns are a useful way to compare them. The investor will always choose the option with the higher dollar return.
Furthermore, the dollar return is useful because it provides an idea about how the assets of a firm will change. If a firm is looking for an additional $50,000 from investment, they will only accept investments with a $50,000 dollar return, regardless of the percent return.
Key Points
- Dollar returns do not take into account things like the time value of money or the time frame of the investment.
- In security
markets, the dollar return of the security is the difference in the
final market price and the market price at which it was purchased.
- Dollar returns are useful for determining the nominal amount that the firm's assets will change.
Term
- Return – gain or loss from an investment.