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. 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 (PATK +1.48%) 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 year's double.
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 nondividend-adjusted simple return:
Annual Dividend-Adjusted Return = (Simple Dividend-Adjusted Return + 1) ^ (1 / Years Held) - 1
Related investing topics
Back to our Campbell's 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 the 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 16, 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).
