Copyright © 2008, The McGraw-Hill Companies, Inc.
Of course, it is possible to lose money on a stock investment as well. This results in a
capital loss, which is indicated by a negative growth rate.Example 6.1.8 Five years ago, I invested $8,400 in the stock of Sehr-Schlecht
Investment Corp. I sold the stock today for $1,750. What compound annual growth
rate does this represent?Applying the formula:i (^) FVPV (^)
1 /n
1
(^) i
$1,750____
$8,400
1/5
1
i 0.2692787 26.93%Work through this example on your calculator now to make sure that you have the correct
steps. If you work it through and come up with a different answer, make sure that you used
the parentheses correctly as discussed after the prior example.Total Rate of Return
The rate of return that we have calculated puts capital gains in terms of a rate of return,
which can be very helpful in evaluating an investment’s performance. However, it
completely ignores any dividends that might have been received along the way. Most
investors are concerned with the overall financial return on their investments, including
both capital gains and dividends. This overall return can be referred to as the total return
on the investment.
Unfortunately, the total rate of return can be a slippery concept. In Example 6.1.7 we
found that the capital gains on your investment in Zarofire Systems resulted in a 21.90%
rate of return, but we also know that the company has paid some dividends along the way.
In Example 6.1.3 we found that the stock’s dividend yield was 3.62%. But that yield is a
moving target; it is based on the market price of the stock, which changes, and also is based
on the dividend at a particular point in time, which has probably not been the same over
the entire 7 years. Also, since you are calculating the return on your original investment,
perhaps we should look at the dividends as a percent of your original investment, not the
current market value when those dividends were paid. To make matters worse, the “total
rate of return” that we are seeking needs to be a compound growth rate that equates to the
return from capital gains, which are compounded, together with the return from dividends,
which are not.
There are a number of different ways of dealing with this, some of them quite com-
plicated. One crude but reasonable approximation for the total return is simply to add the
compound growth rate from capital gains to a rate that represents an “average” dividend
yield for the stock over time. This is only an approximation of the total return rate, and
can not be taken too literally, but does provide a reasonable enough estimate of total return
for many purposes.Example 6.1.9 The dividend yield rate on Zarofi re Systems has been on average
around 3½% over the time you’ve owned it. What is the approximate total rate of
return you have received on this investment?Using the approach discussed above, we fi nd the total rate of return is approximately 21.90%
3.50% 25.40%.The total return idea would be much simpler if the dividends were paid in company stock
instead of in cash. In that case, the dividends would earn compound growth, as dividends
are paid on the stock dividends, and so on. Many companies offer dividend reinvestment
plans. The money-dividends earned on stocks owned in these plans are not paid out to the
stockholder, but are instead used to purchase more stock at the market price. (The dividends
are still taxed as income, though, since you still had the option of taking them in cash.)6.1 Stocks 257