An annual return, or annualized return, is a percentage that tells you how much an investment has increased in value on average per year over a period of time.

Annual return can be a preferable metric to use over simple return when you want to evaluate how successful an investment has been, or to compare the returns of two investments you've held over different time frames on equal footing: An investment that's doubled in five years is obviously preferable to another investment that's taken 50 years to double. An annual return allows you to compare the two.

How not to calculate an annual return
Your broker can help you determine what your returns have been on your investments -- but if you don't have a broker yet, come on over to our Broker Center, and we'll help you get started. In the meantime, know that you can't merely divide your simple return by the number of years held because of the compounding power of money. We can use a dramatic example to illustrate why.

Building-products manufacturer Patrick Industries is a dramatic produced an average annual return of close to 100% for the five years leading up to late 2015, meaning the stock doubled on average every year for five years. If you try to calculate its annual return by dividing its simple return by five, you'd get the wrong answer. (3,100% / 5 = 620%, not 100%.) That's because returns compound -- a double in year two doesn't just double the original stock value, but it also doubles the previous years double.

How to calculate an annual return
Here's how to do it correctly:

  • Look up the current price and your purchase price.

  • If the stock has undergone any splits, make sure the purchase price is adjusted for splits. If it isn't, you can adjust it yourself. For example, if you held a stock for 4 years, during which time it has had a 2:1 and a 3:1 split, then you can calculate your split-adjusted purchase price by dividing your purchase price by 6 (2 x 3).

  • Calculate your simple return percentage:

Simple Return = (Current Price-Purchase Price) / Purchase Price

  • Now that you have your simple return, annualize it:

Annual Return = (Simple Return +1) ^ (1 / Years Held)-1

Let's use Campbell Soup as an example. Suppose it's 2015, and you own shares (it doesn't matter how many) of the stock. Campbell's stock trades for $48 per share, and you paid $54 per share 20 years ago in 1995. In the meantime, the stock has undergone one split, a 2:1 split in 1997.

  • The current price is $48. Your purchase price was $54.
  • Your split-adjusted purchase price would be $27 ($54 / 2).
  • Your simple return would be 78% ($48-$27) / $27).
  • Your annual return would be 3% ((78% +1 ) ^ (1 / 20)-1).

What about dividends?
Many companies pay their investors cash in the form of dividends. Since dividends can make up a substantial portion of investing returns, you may decide to calculate an annual return that takes them into account.

Here's how:

  • Calculate your simple return using a historical dividend-adjusted historical price. (Also known as adjusted price or adjusted close price, a dividend-adjusted price usually will take into account any splits. It also implicitly assumes dividend reinvestment.)

Simple Dividend-Adjusted Return = (Current Stock Price-Dividend-Adjusted Stock Purchase Price) / Dividend-Adjusted Stock Purchase Price

  • Annualize your dividend-adjusted simple return in the same way as a non-dividend adjusted simple return:

Annual Dividend-Adjusted Return = (Simple Dividend-Adjusted Return +1) ^ (1 / Years Held)-1

Back to our Campbell Soup example. The company paid a bunch of dividends from 1995 to 2015. Here's how you would include those in your annual return calculation:

  • The current price stays that same -- $48. Instead of using a purchase price of $54, look up the dividend-and-split-adjusted historical price on your purchase date. Let's say you bought on November 16th, 1995. Your dividend-and-split-adjusted close price would be $15.27.
  • Your simple dividend-adjusted return would be 314% ($48-$15.27) / $15.27).
  • Your annual dividend-adjusted return would be 7% ((314% + 1) ^ (1 / 20) -1).

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at knowledgecenter@fool.com. Thanks -- and Fool on!