Gross Return vs. Net Return: How Do You Measure Return Correctly?

For most private investors, the return is the decisive figure to measure the success of their investments. Return describes how successfully an investment has developed over a specified period of time.  It is measured by the return on an investment and expressed as a percentage. Return and risk are closely related: the higher the risk of an investment, the higher the potential return.

No matter if a private investor stores his or her assets in a call money account, invests them in shares or funds, or grants them to startups as fixed-interest loans – the success of each can be measured by the return. However, private investors tend to confuse gross and net returns. This gives them a wrong picture of how successful the investment really was. We will explain the difference between the two and how to calculate both in the following.

Return does not equal return: Gross vs. net

There are different forms of return: Gross return (also known as the nominal return or nominal interest) and net return (also known as the real return or effective interest). This difference plays a decisive role when private investors evaluate the success of their investment. Gross return shows the development of an investment over a certain period of time (usually one year). It only shows the interest on an asset; it does not take into account all costs incurred in connection with the acquisition of the asset.

When a private investor deposits money into a bank account, the interest on the deposit is equal to the gross return. Although most call and fixed money accounts no longer have account opening or account management fees, their interest earnings are subject to other factors such as taxation and inflation, which reduce gross return. For this reason, the real return is a better figure for private investors to measure the yield from their investment.

Return is reduced by costs, taxes, and inflation

In comparison to gross return, net return considers all costs associated with the acquisition of the investment. First of all, the costs of an investment include transaction costs. Private investors must first open a deposit account to purchase shares, bonds, fund units, and derivatives. Deposit opening fees and deposit management fees may vary depending on the provider. Next, most brokers charge a transaction fee for each transaction executed, i. e. the purchase or sale of a security. Transaction costs reduce the return private investors achieve with their investments. They must, therefore, be deducted from the final return.

One should also consider annual inflation when calculating real return because inflation influences return. Inflation describes the progressive devaluation a currency is subject to. It is viewed over a limited period of time (usually one year) and expressed as a percentage.

A currency loses purchasing power due to inflation, which also affects the return on an investment. Therefore, inflation should be included in the calculation of real return. If, for example, annual inflation is 2% and the nominal return on an investment is 1%, the investor will actually have made a negative real return in the course of one year.

Finally, taxes that private investors have to pay on their investment income are also included in the calculation of the effective interest rate. These include a tax on capital gains, flat-rate tax, solidarity surcharge, and, if applicable, church tax. In 2009, the Federal Government of Germany passed the Flat-Rate Withholding Tax Law, which regulates income taxes on private investment earnings. This includes income from interest, dividends, and appreciation through the sale of securities.

We have created a tax guideline for equity crowdfunding yields, which investors can use to orient themselves. In general, these yields are subject to 25% capital gains tax, 5.5% solidarity surcharge, and church tax, if applicable. Taxation also depends on the country that the investor pays taxes in and on the country in which his or her investment object is located. Since the tax regulations are very complex, private investors should always consult a tax advisor.

Correctly calculating return: An example

Let’s look at an example to clarify the difference between nominal and real return. An investor invests EUR 100 in a share of a DAX group at a price of EUR 25 per share. At the end of the year, the share has a price of EUR 28. To invest in a share, the investor first has to open a deposit for a one-time fee of EUR 1. In addition, the broker charges 50 cents per transaction. Annual inflation is 2%. The capital gains tax is 20%. How much is the nominal return? How much is the real return?

Gross return: With EUR 100, the investor can acquire 4 shares at EUR 25 each. The share price at the end of the year is EUR 28. Thus, the investor has made EUR 3 profit per share through the price increase. His total assets after one year are EUR 112; the yield of one year was EUR 12. This equals a gross return of 12%.

Real return: All costs have to be considered to calculate the real return. This means we deduct the deposit opening fee of EUR 1 and the transaction fees of EUR 1 (50 cents for the purchase and 50 cents for the sale) from the annual yield of EUR 12. We arrive at an annual yield of EUR 10, to which we apply 20% tax. This equals a tax burden of EUR 2, reducing our yield to EUR 8, or 8% annual return. After deducting the inflation of 2% from this 8%, we arrive at a real return of 6% – which is only half as much as the gross return.

In equity crowdfunding, investors generate returns from the startup’s exit. We provide a return calculator on our site to calculate the gross return on equity crowdfunding. There, investors can calculate what exit yields to expect from the sale of a startup. These values are derived from past sales proceeds generated by startups in the same industry with comparable sales.

It can also show the effect of dilution, which has a negative effect on the total return. Equity crowdfunding does not charge any transaction costs or deposit fees. However, inflation and taxes must still be taken into account in order to calculate the real return.

Do you have any questions or comments on the subject of returns? Let us know in the comments below!