What is annual return?

Understanding annual return is important for both business owners and investors. In this guide, we’ll explain what it is, how to figure it out, and why it matters.

Specifically, we’ll be covering:

• What is annual return?
• Why are annual returns important?
• How to calculate annual return
• Reporting annual return
• How is annual return different from average return?

When people talk about annual return they’re really talking about the amount of money that they’ll get back from an investment over a period of time. 

It’s usually calculated in one-year chunks, but an annual return figure will usually spread across several years to give the investor an idea of their returns over a longer period of time. 

The figure is given as a percentage of the original investment. And a number of different forms of income can be count toward the annual return, including:

• Dividends
• Returns on capital 
• Capital appreciation 

Although annual return is a useful figure, it doesn’t take into account any market price changes or inflation that might affect the end figures. 

Annual return itself is an important figure because it shows how profitable a company actually is. But the figure is useful for other parts of financial strategy. 

Knowing your annual return for one year will allow you to make projections about your annual returns in future years, meaning you can plan ahead and prepare for expansion. 

When applying for a business loan, most banks will ask for some form of business plan. Having good annual return figures and projections will make you a much safer investment for them. 

Much like the banks, private investors also want some assurance that they’ll see some return on their investment. Annual return figures are often used to attract investors, usually with annual return projections over several years. 

If you have a record of your actual annual return figures, you can accurately say, “if you’d invested £1000 with us five years ago, you’d have this much today.” 

As we mentioned earlier, annual return figures are more useful when they cover a period of more than one year. To get that figure, you need to use this formula:

(1 + overall return rate) ^ (1 / N) – 1 = annual return

N = number of periods measured

Overall return rate = (ending value – beginning value) / beginning value

For example, let’s say you’ve invested £1,000 and its value grew to £1,500 over a year. In that case, N = 1 (one year), and the return rate is (1,500 – 1,000) / 1000 = 0.5.

Because we’re just using one year for our time period, putting this return rate into the formula would still show us an annual return rate of 0.5, or 50%. 

(1 + 0.5) ^ (1 / 1) – 1 = 0.5

or

(1.5) ^ (1) – 1 = 0.5

or

1.5 – 1 = 0.5

If you wanted to break down that year into smaller periods, you could jut replace N with a different figure, such as:

• Days: (1 + 0.5) ^ (1 / 365) – 1 = daily return rate
• Weeks: (1 + 0.5) ^ (1 / 52) – 1 = weekly return rate
• Months: (1 + 0.5) ^ (1 / 12) – 1 = monthly return rate

To get the annual return rate for large periods, we use the exact same formula as before but with a different N value once again.

For example, let’s say you invested the same amount of money (£1,000), and that investment grew to the same value (£1,500), but this time it was over a five year period. 

In that case, you’d use all the same figures as before, but now N = 5, so it’d work out like this:

(1 + 0.5) ^ (1 / 5) – 1 = annual return rate

or

(1.5) ^ (0.2) – 1 = annual return rate

or 

1.08 – 1 = 0.08

In this case, the annual return rate is much lower than before because the total return rate (0.5) is the same but the period of time (N) is five years instead of one. 

When it comes to reporting your annual return, there are principles outlined by the Global Investment Performance Standards (GIPS). 

GIPS sets out a set of ethical principles agreed upon by everyone involved with investment to prevent anybody from reporting misleading information about their return rates. 

The main principle in terms of annual reporting is that a company can’t report an annual return rate unless it has been operating for at least one year. 

The principle ensures that any annual return reports are based on actual values, instead of predicted values. 

While average return sounds quite similar to annual return, it’s important to know there are a few crucial differences between them. 

They’re both trying to do the same thing, show the return rate of an investment over time, but they’re calculated in different ways. 

The average return rate is worked out by dividing the overall return rate by the total time period of the investment, like this:

Overall return rate / N = average return rate

If we used our figures from earlier, it would look like this:

((1,500 – 1,000) / 1000) / 5 = average return rate

or

0.5 / 5 = 0.1

You can see here that the average return rate is slightly higher than the annual return rate, using the exact same figures. 

The figures are different because the average return rate doesn’t account for compounding. In other words, annual return rates calculations consider each individual year’s return rate, rather than all of them at once. 

Because of this, annual return rates are usually seen as more accurate representations of investment returns. 

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