Trading

What is the difference between a company's annual return and its annualized return?

A:

For most investors, determining whether an investment in a particular company or mutual fund is worthwhile comes down to an analysis of its performance. However, measuring an investment's performance is not always as simple as adding up or averaging returns. To get a clear picture of an investment's return over time, it's important for investors to understand the difference between annual return and annualized return. Annual return is defined as the percentage change in an investment over a one-year period; annualized return is the percentage change in an investment measured over periods of time shorter or longer than one year but stated as a yearly rate of return.

Annual Return

Being able to calculate the annual return of a company or other investment provides investors the ability to analyze performance over any given year the investment is held. The annual return calculation is more simplistic than an annualized return calculation, and as such, it's used more frequently among investors. To calculate annual return of a company or investment, investors must first determine the initial price of the investment at the beginning of the time period in question. Then, the price of the investment at the end of the one-year period is found. The initial price is subtracted from the end price to determine the investment's change in price over time.

Once the change in price is calculated, that figure is divided by the initial price of the investment. For example, a company with a stock price of $50 on January 1 that increases to $75 by December 31 of the same year

has a change in price of $25. That amount divided by the initial price of $50 results in a 0.5, or 50% increase for the year. Although the annual return provides investors with the total change in price over the one-year period, the calculation does not take into account volatility of the stock price over that time frame.

Annualized Return

A company or investment's annualized return can be used in a variety of ways to evaluate performance over time. In most cases, it's meaningful when used to compare companies with varied lengths of operational history or to project out rates of return for companies with less than a year of performance data. To calculate the annualized rate of return, investors must first determine the total return. This is the same calculation as annual return (ending investment price - initial investment price / initial investment price), but is based on the full investment time frame, regardless of whether it's shorter or longer than a one-year period.

Once the total return is calculated, the annualized total return is determined by plugging the corresponding values into the following equation: (1+total return)^1/N - 1. The variable N represents the number of periods being measured, and the exponent 1 represents the unit of one year being measured. For example, a company with an initial price of $1,000 and an ending price of $2,500 over a seven-year period would have a total return of 150% (2,500 - 1,000 / 1,000). The annualized return equates to 13%, with 7 substituted for the variable N: (1 + 1.50)^1/7 - 1.


Category: Investment

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