PART 2: VAlUATION, RISK AND RETURN6 -1 UNDERSTANDING RETURNS
Probably the first question that investors ask when they decide whether or not to undertake an investment
is, ‘How much money will this investment earn?’ In finance, we refer to the total gain or loss on an
investment as the total return. The total return, expressed either in dollar terms or on a percentage basis,
measures the change in wealth that an investor experiences from holding a particular asset, such as an
ordinary share or a bond.6 -1a THE COMPONENTS OF TOTAl RETURN
An investment’s total return consists of two components. The first is the income stream the investment
produces. For bonds, the income stream comes in the form of interest. For ordinary or preferred shares,
dividends provide the income stream. As we learned in Chapters 4 and 5, the financial press regularly
provides investment performance measures that primarily focus on an asset’s income stream. For example,
the coupon yield, which equals the coupon payment divided by the bond’s market price, describes how
much money the bondholder earns in interest as a percentage of the bond’s price. Similarly, the dividend
yield, equal to a share’s annual dividend payment divided by the share price, highlights the income
component of share returns.
Measures such as the coupon yield and dividend yield may provide investors with useful information,
but any performance measure that focuses entirely on an investment’s income stream misses the second,
and often the most important, component of total returns. That component is the change in the asset’s
price, called the capital gain or capital loss. For some investments, such as zero-coupon bonds and shares
that do not pay dividends, the capital gain or loss is the only component of total return because there is no
income. For other investments, the price change may be more or less important than the income stream
in determining the investment’s total return.
For example, suppose an investor spends $1,000 to purchase a newly issued 10-year corporate bond
that pays an annual coupon of $60. In this case, the coupon rate and the coupon yield are both 6% ($60 ÷
$1,000). Because this bond sells at par value, we know that the market requires a 6% return on the bond.
Suppose we want to assess the performance of this investment after one year. To do so, we need to add
up both the income paid by the bond and any price change that occurs during the year. At the end of the
year, the investor receives a $60 coupon payment; but what is her bond worth? We know from Chapter
4 that the answer to that question depends on what happens to market interest rates during the year.
Suppose the market’s required return has risen from 6% to 8%. At the end of the first year, the bond has
nine years left until maturity. Discounting the remaining cash flows at 8%, we find that the bond’s market
price equals just $875.06:
$60
1.08$60
1.08$60
1.08...
$1, 060
1.08P=+ 12 ++ 39 +=$875.06
The investor’s total return is considerably less than the 6% coupon yield. In fact, the capital loss
caused by rising interest rates results in a negative total return. The investor earns income of $60, but she
also experiences a capital loss of $124.94 ($1,000 – $875.06). That loss more than offsets the interest
payment, and our investor ends the year with less wealth than she started it with.
Note that the investor’s total return this year does not depend on whether she sells the bond or
continues to hold it. Selling or not selling the bond determines whether the capital loss in this example iscapital loss
The decrease in the price of an
asset that occurs over a period
of time
capital gain
The increase in the price of an
asset that occurs over a period
of time
total return
A measure of the performance
of an investment that captures
both the income it paid out to
investors and its capital gain
or loss over a stated period
of time
LO6.1