Should the Market Value or Equity Be Used in the Rate of Return?
Original post by Walter Johnson of Demand Media
The "rate of return" concept is not necessarily a simple one. Several variables must be taken into consideration when dealing with valuing assets. The use of book value, or equity value, makes sense only for investments with a fixed rate of return. All others are market based. If you are defining return as "profit," then both must be used.
The two simple methods of valuation are book value and market value. The former is the value of the asset upon purchase, minus any depreciation. The latter is the price that asset will fetch on the open market. Often, the two values are markedly different.
Calculating a rate of return means determining, all other variables being equal, how much profit you, the investor, will realize from a certain asset. The asset can be a bond, stock, capital equipment or land. It can even be intangible items, like a new idea or talented management. The problem is that the rate of return is not calculated in the same way for all of these. For bonds, the book value relative to its interest rate and maturity date are the main variables for calculating its return. It is, in other words, fixed. Stock only realizes a return and/or a capital gain given its market value.
Market vs. Book
If you are calculating the return rate on a bond, then life is easy. The book value, or equity value, is all you need, since the interest rate, maturity and face value of the bond are all that matters. Even in variable-rate bonds, if the rate changes with the money market, the face value of the bond itself changes accordingly. In other words, if the rate goes up, the face value of the bond goes down, since the face value of the bond is intrinsically connected to its coupon, or face, interest rate. If you are calculating a share of stock, then the market value is the only thing that matters. Often, stock prices have no relation to the actual value of the firm, its equipment or its product. Stock prices can be inflated through overinvestment, a spike in demand or a fad. While stock prices can be completely "false" in that they do not represent the actual value of the firm at any level --- your stock is overvalued --- at least for the very short term, the stock can be quickly traded at a large profit.
When valuing capital, the two methods can be used depending on who you are valuing for. If you own modern capital stock for a factory and are reporting for the IRS, you use only its equity value. If you are selling the equipment that helps produce a high-demand product, such as oil-refining equipment, the market value will be far higher than its original price and the depreciation factor. If you want to figure out the rate of return on oil-refining equipment, you begin with the book value and depreciation, and then add to the calculation the amount of daily or monthly profit that such equipment produces given the current price of oil and gas. Therefore, the accurate measure of return will make use of both variables, though in different ways.
- Oracle Education Foundation: Calculating the Rate of Return on Investments
- Money Terms: Accounting Rate of Return (ARR)
- Money Terms: Time Value of Money
- BondView: Determining Bond Values
About the Author
Walter Johnson has more than 20 years experience as a professional writer. After serving in the United Stated Marine Corps for several years, he received his doctorate in history from the University of Nebraska. Focused on economic topics, Johnson reads Russian and has published in journals such as “The Salisbury Review,” "The Constantian" and “The Social Justice Review."