In the simplest form, the average yield calculation equals the investment's annual income divided by the cost of acquisition. The average yield on an investment is related to another important financial calculation, the return on investment (ROI), but involves a different calculation for a somewhat different purpose. The more widely known ROI is essentially backward looking - what was the percentage made? The average yield expresses an investment's present or future state.
A Tricky Little Difference
Sometimes investors don't distinguish between ROI and yield. There's a good reason. If you buy an asset for $100 and sell it for $110, what's the percentage you've returned on your investment? You determine that by dividing the profit, $10, by the cost, $100. The answer's 10 percent.
Similarly, if you hold a preferred stock for one year with a par value of $100 and a stated annual dividend rate of 10 percent - its yield - you're going to make $10.
At first glance, it might seem that yield and return are just two different words for the same thing.
In fact, they're not. In the first instance, you've bought the asset for $100 and sold it for $110, end of story. You made $10, and in this instance, that's 10 percent, but it's 10 percent now and forever. The transaction's in the past.
In the second instance, you're holding the stock; you haven't sold it. The 10 percent yield is in the present.
How the Difference between Return and Yield Matters
To see how the difference between these concepts can matter, consider a couple of more advanced examples, ones more closely related to the complexities of investments in the real world.
A Preferred Share With a Par Value of 100 and Yield of 4 Percent. You buy the share, hold it for two years, then sell it. With the yield being 4 percent, over two years you've made $8. Or, at least that's what you'd anticipated. However, during the second year, the company began having some problems. Common shares lost 20 percent of their value. While preferred stock dividends are guaranteed, they're only paid if the company has sufficient liquidity to make the payment. In other words, the risk of holding your share of preferred stock has increased and in response, the share value has dropped. It wasn't as bad as the drop in common shares, but you could only sell it for $95, not the $100 you paid. While the yield over the two years you held it remains 4 percent - you did get your $8, despite the increased risk - the return on investment has changed. You lost $5 on the sale of the shares. Your net gain being purchase price minus sales plus dividends received, which is -$5 plus $8, or $3 during the two years you held it, which is $1.50/ year. Your return on investment is 1.5 percent/annum, which is significantly less than the 4 percent/annum yield.
You buy a rental property for $200,000. After collecting rent for the year, netting taxes and upkeep and excluding depreciation, you have $12,000. For the year, your yield is 12,000/$200,000, or 6 percent.
You now sell the property into a hot real estate market for $220,000. Your return on investment is the difference between acquisition and sale, $20,000, plus the $12,000 in net rental income, which totals $32,000. 32,000/200,000 or 16 percent is the annual return on investment.
Return on investment includes all net income, including capital gains; yield does not.