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What Is Accounting Rate of Return (ARR)?

Thursday 3-18-21

Accounting rate of return (ARR) is a formula that reflects the percentage rate of return expected on an investment, or asset, compared to the initial investment's cost. 

The ARR formula divides an asset's average revenue by the company's initial investment to derive the ratio or return that one may expect over the lifetime of the asset, or related project. 

ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining a business.

---What Is an Asset?

An asset is a resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide a future benefit. 

Assets are reported on a company's balance sheet and are bought or created to increase a firm's value or benefit the firm's operations.

An asset can be thought of as something that, in the future, can generate cash flow, reduce expenses, or improve sales, regardless of whether it's manufacturing equipment or a patent. 

---What Is Revenue?

Revenue is the income generated from normal business operations and includes discounts and deductions for returned merchandise. 

It is the top line or gross income figure from which costs are subtracted to determine net income.

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Sales Revenue=Sales Price×Number of Units Sold

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Revenue is also known as sales on the income statement. It is vital for a startup to get positive revenue early.

---What Is the Time Value of Money (TVM)?

The time value of money (TVM) is the concept that money you have now is worth more than the identical sum in the future due to its potential earning capacity. 

This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also sometimes referred to as present discounted value.

---What Is After-Hours Trading?

After-hours trading starts at 4 p.m. U.S. Eastern Time after the major U.S. stock exchanges close. 

The after-hours trading session can run as late as 8 p.m., though volume typically thins out much earlier in the session. Trading in the after-hours is conducted through electronic communication networks (ECNs).

---What Is an Electronic Communication Network?

An electronic communication network (ECN) is a computerized system that automatically matches buy and sell orders for securities in the market. 

It connects major brokerages and individual traders so they can trade directly between themselves without going through a middleman and make it possible for investors in different geographic locations to quickly and easily trade with each other. 

The U.S. Securities and Exchange Commission (SEC) requires ECNs to register as broker-dealers.

---What is Alpha

Alpha (α) is a term used in investing to describe an investment strategy's ability to beat the market, or it's "edge." 

Alpha is thus also often referred to as “excess return” or “abnormal rate of return,” which refers to the idea that markets are efficient, and so there is no way to systematically earn returns that exceed the broad market as a whole. 

Alpha is often used in conjunction with beta (the Greek letter β), which measures the broad market's overall volatility or risk, known as systematic market risk.

Alpha is used in finance as a measure of performance, indicating when a strategy, trader, or portfolio manager has managed to beat the market return over some period. 

Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark that is considered to represent the market’s movement as a whole. 

The excess return of an investment relative to the return of a benchmark index is the investment’s alpha. 

Alpha may be positive or negative and is the result of active investing. Beta, on the other hand, can be earned through passive index investing.

---What is Volatility?

Volatility is a statistical measure of the dispersion of returns for a given security or market index. 

In most cases, the higher the volatility, the riskier the security. 

Volatility is often measured as either the standard deviation or variance between returns from that same security or market index.

In the securities markets, volatility is often associated with big swings in either direction.

For example, when the stock market rises and falls more than one percent over a sustained period of time, it is called a "volatile" market. 

An asset's volatility is a key factor when pricing options contracts.

---What Is Systematic Risk?

Systematic risk refers to the risk inherent to the entire market or market segment. 

Systematic risk, also known as “undiversifiable risk,” “volatility” or “market risk,” affects the overall market, not just a particular stock or industry. 

This type of risk is both unpredictable and impossible to completely avoid. 

It cannot be mitigated through diversification, only through hedging or by using the correct asset allocation strategy.