What Is an Annual Return?

The annual return is the return that an investment provides over a period of time, expressed as a time-weighted annual percentage. Sources of returns can include dividends, returns of capital and capital appreciation. The rate of annual return is measured against the initial amount of the investment and represents a geometric mean rather than a simple arithmetic mean.

Understanding Annual Return

The de facto method for comparing the performance of investments with liquidity, an annual return can be calculated for various assets, which include stocks, bonds, funds, commodities and some types of derivatives. This process is a preferred method, considered to be more accurate than a simple return, as it includes adjustments for compounding interest. Different asset classes are considered to have different strata of annual returns.

Annual Returns on Stocks

Also known as an annualized return, the annual return expresses the stock’s increase in value over a designated period of time. In order to calculate an annual return, information regarding the current price of the stock and the price at which it was purchased are required. If any splits have occurred, the purchase price needs to be adjusted accordingly. Once the prices are determined, the simple return percentage is calculated first, with that figure ultimately being annualized. The simple return is just the current price minus the purchase price, divided by the purchase price.

Example Annual Return Calculation


$\begin{aligned} &\text{CAGR} = \left ( \left ( \frac{ \text{Ending Value} }{ \text{Beginning Value } } \right ) ^ \frac{ 1 }{ \text{Years} } \right ) – 1 \\ &\textbf{where:} \\ &\text{CAGR} = \text{compound annual growth rate} \\ &\text{Years} = \text{holding period, in years} \\ \end{aligned}$​CAGR=((Beginning Value Ending Value​)Years1​)−1where:CAGR=compound annual growth rateYears=holding period, in years​

Consider an investor that purchases a stock on Jan. 1, 2000, for $20. The investor then sells it on Jan. 1, 2005, for $35 – a $15 profit. The investor also receives a total of $2 in dividends over the five-year holding period. In this example, the investor’s total return over five years is $17, or (17/20) 85% of the initial investment. The annual return required to achieve 85% over five years follows the formula for the compound annual growth rate (CAGR):


$\begin{aligned} &\left ( \left ( \frac { 37 }{ 20 } \right ) ^ \frac{ 1 }{ 5 } \right ) – 1 = 13.1\% \text{ annual return} \\ \end{aligned}$​((2037​)51​)−1=13.1% annual return​

The annualized return varies from the typical average and shows the real gain or loss on an investment, as well as the difficulty in recouping losses. For instance, losing 50% on an initial investment requires a 100% gain the next year in order to make up the difference. Because of the sizable difference in gains and losses that can occur, annualized returns help even out investment results for better comparison. 

Annual Returns on a 401K

The calculation differs when determining the annual return of a 401K during a specified year. First, the total return must be calculated. The starting value for the time period being examined is needed, along with the final value. Before performing the calculations, any contributions to the account during the time period in question must be subtracted from the final value.

Once the adjusted final value is determined, it is divided by the starting balance. Finally, subtract 1 from the result and multiply that amount by 100 to determine the percentage total return.

What Is the Average Cost Basis Method?

The average cost basis method is a system of calculating the value of mutual fund positions held in a taxable account to determine the profit or loss for tax reporting. Cost basis represents the initial value of a security or mutual fund that an investor owns.

The average cost is then compared with the price at which the fund shares were sold to determine the gains or losses for tax reporting. The average cost basis is one of many methods that the Internal Revenue Service (IRS) allows investors to use to arrive at the cost of their mutual fund holdings.

Understanding the Average Cost Basis Method

The average cost basis method is commonly used by investors for mutual fund tax reporting. A cost basis method is reported with the brokerage firm where the assets are held. The average cost is calculated by dividing the total amount in dollars invested in a mutual fund position by the number of shares owned. For example, an investor that has $10,000 in an investment and owns 500 shares would have an average cost basis of $20 ($10,000 / 500).

Types of Cost Basis Methods

Although many brokerage firms default to the average cost basis method for mutual funds, there are other methods available.

FIFO

The first in, first out (FIFO) method means that when shares are sold, you must sell the first ones that you acquired first when calculating gains and losses. For example, let’s say an investor owned 50 shares and purchased 20 in January while purchasing 30 shares in April. If the investor sold 30 shares, the 20 in January must be used, and the remaining ten shares sold would come from the second lot purchased in April. Since both the January and April purchases would have been executed at different prices, the tax gain or loss would be impacted by the initial purchase prices in each period.

Also, if an investor has had an investment for more than one year, it would be considered a long-term investment. The IRS applies a lower capital gains tax to long-term investments versus short-term investments, which are securities or funds acquired in less than one year. As a result, the FIFO method would result in lower taxes paid if the investor had sold positions that were more than a year old.

LIFO

The last in first out (LIFO) method is when an investor can sell the most recent shares acquired first followed by the previously acquired shares. The LIFO method works best if an investor wants to hold onto the initial shares purchased, which might be at a lower price relative to the current market price.

High-Cost and Low-Cost Methods

The high-cost method allows investors to sell the shares that have the highest initial purchase price. In other words, the shares that were the most expensive to buy get sold first. A high-cost method is designed to provide investors with the lowest capital gains tax owed. For example, an investor might have a large gain from an investment, but doesn’t want to realize that gain yet, but needs money.

Having a higher cost means the difference between the initial price and the market price, when sold, will result in the smallest gain. Investors might also use the high-cost method if they want to take a capital loss, from a tax standpoint, to offset other gains or income.

Conversely, the low-cost method allows investors to sell the lowest-priced shares first. In other words, the cheapest shares you purchased get sold first. The low-cost method might be chosen if an investor wants to realize a capital gain on an investment.

Choosing a Cost-Basis Method

Once a cost basis method has been chosen for a specific mutual fund, it must remain in effect. Brokerage firms will provide investors with appropriate annual tax documentation on mutual fund sales based on their cost basis method elections.

Investors should consult a tax advisor or financial planner if they are uncertain about the cost basis method that will minimize their tax bill for substantial mutual fund holdings in taxable accounts. The average cost basis method may not always be the optimal method from a taxation point of view. Please note that the cost basis only becomes important if the holdings are in a taxable account, and the investor is considering a partial sale of the holdings.

Specific Identification Method

The specific identification method (also known as specific share identification) allows the investor to choose which shares are sold in order to optimize the tax treatment. For example, let’s say an investor purchases 20 shares in January and 20 shares in February. If the investor later sells 10 shares, they can choose to sell 5 shares from the January lot and 5 shares from the February lot.

Example of Cost Basis Comparisons

Cost basis comparisons can be an important consideration. Let’s say that an investor made the following consecutive fund purchases in a taxable account:

• 1,000 shares at $30 for a total of $30,000
• 1,000 shares at $10 for a total of $10,000
• 1,500 shares at $8 for a total of $12,000

The total amount invested equals $52,000, and the average cost basis is calculated by dividing $52,000 by 3,500 shares. The average cost is $14.86 per share.

Suppose the investor then sells 1,000 shares of the fund at $25 per share. The investor would have a capital gain of $10,140 using the average cost basis method. The gain or loss using average cost basis would be as follows:

• ($25 – $14.86) x 1,000 shares = $10,140.

Results can vary depending on the cost-basis method chosen for tax purposes:

• First in first out: ($25 – $30) x 1,000 shares = – $5,000
• Last in first out: ($25 – $8) x 1,000 = $17,000
• High cost: ($25 – $30) x 1,000 shares = – $5,000
• Low cost: ($25 – $8) x 1,000 = $17,000

From strictly a tax standpoint, the investor would be better off selecting the FIFO method or the high-cost method to calculate the cost basis before selling the shares. These methods would result in no tax on the loss. However, with the average cost basis method, the investor must pay a capital gains tax on the $10,140 in earnings.

Of course, if the investor sold the 1,000 shares using the FIFO method, there’s no guarantee that when the remaining shares are sold that $25 will be the selling price. The stock price could decrease, wiping out most of the capital gains and an opportunity to realize a capital gain would have been lost. As a result, investors must weigh the choice as to whether to take the gain today and pay the capital gains taxes or try to reduce their taxes and risk losing any unrealized gains on their remaining investment.

What Is at Par?

The term “at par” means at face value. A bond, preferred stock, or other debt instrument may trade at par, below par, or above par.

Par value is static, unlike market value, which fluctuates with credit ratings, time to maturity, and interest rate fluctuations. The par value is assigned at the time the security is issued. When securities were issued in paper form, the par value was printed on the face of the security, hence the term “face value.”

Understanding at Par

Due to the constant fluctuations of interest rates, bonds and other financial instruments almost never trade exactly at par. A bond will not trade at par if current interest rates are above or below the bond’s coupon rate, which is the interest rate that it yields.

A bond that was trading at par would be quoted at 100, meaning that it traded at 100% of its par value. A quote of 99 would mean that it is trading at 99% of its face value.

Par value for common stock exists in an anachronistic form. In its charter, the company promises not to sell its stock at lower than par value. The shares are then issued with a par value of one penny. This has no effect on the stock’s actual value in the markets.

A New Bond

If, when a company issues a new bond, it receives the face value of the security, the bond is said to have been issued at par. If the issuer receives less than the face value for the security, it is issued at a discount. If the issuer receives more than the face value for the security, it is issued at a premium.

The yield for bonds and the dividend rate for preferred stocks have a material effect on whether new issues of these securities are issued at par, at a discount, or at a premium.

A bond that trades at par has a yield equal to its coupon. Investors expect a return equal to the coupon for the risk of lending to the bond issuer.

Example of at Par

If a company issues a bond with a 5% coupon, but prevailing yields for similar bonds are 10%, investors will pay less than par for the bond to compensate for the difference in rates. The bond’s value at its maturity plus its yield up to that time must be at least 10% to attract a buyer.

If prevailing yields are lower, say 3%, an investor is willing to pay more than par for that 5% bond. The investor will receive the coupon but have to pay more for it due to the lower prevailing yields.

What Is an Appropriation?

Appropriation is when money is set aside for a specific purpose. A company or a government appropriates funds in order to delegate cash for the necessities of its operations. Appropriations for the U.S. federal government are decided by Congress through various committees. A company might appropriate money for short-term or long-term needs that include employee salaries, research and development, and dividends.

What Does an Appropriation Tell You?

Appropriations tell us how money or capital is being allocated whether it’s through the federal government’s budget or a company’s use of cash and capital. Appropriations by governments are made for federal funds each year for various programs. Appropriations for companies may also be known as capital allocation.

Appropriation could also refer to setting apart land or buildings for public use such as for public buildings or parks. Appropriation can also refer to when the government claims private property through eminent domain.

Federal Appropriations

In the United States, appropriations bills for the federal government’s spending are passed by U.S. Congress. The government’s fiscal year runs from October 1 through September 30 of each calendar year.

Each fiscal year, the U.S. President submits a budget proposal to Congress. Budget committees in the U.S. House and Senate, then determine how the discretionary portion of the budget will be spent through a budget resolution process. The process yields an allocation of an amount of money that is assigned to the various appropriations committees. The House and Senate appropriations committees divide the money up between the various subcommittees that represent the departments that’ll receive the money. Some of the departments include the following:

• Department of Agriculture
• Department of Defense
• Department of Energy
• Department of Commerce
• Department of Labor
• Department of Transportation

Federal programs such as Social Security and Medicare fall under the mandatory expenditures category and receive funding through an automatic formula rather than through the appropriations process.

Congress also passes supplemental appropriations bills for instances when special funding is needed for natural disasters and other emergencies. For example, in December 2014, Congress approved the Consolidated and Further Continuing Appropriations Act, 2015. The act approved $5.2 billion to fight the Ebola virus in West Africa and for domestic emergency responses to the disease. The act also allocated funding for controlling the virus and developing treatments for the disease.

Appropriations in Business

Corporate appropriations refer to how a company allocates its funds and can include share buybacks, dividends, paying down debt, and purchases of fixed assets. Fixed assets are property, plant, and equipment. In short, how a company allocates capital spending is important to investors and the long-term growth prospects of the company.

How a company appropriates money or invests its cash is monitored closely by market participants. Investors watch to determine whether a company is using its cash effectively to build shareholder value or whether the company is engaged in frivolous use of its cash, which can lead to the destruction of shareholder value.

Monitoring Corporate Appropriations

Investors monitor corporate appropriations of cash by analyzing a company’s cash flow statement. The cash flow statement (CFS) measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses. The cash flow of a company is divided into three activities or behavior:

1. Operating activities on the cash flow statement include any sources and uses of cash from business activities such as cash generated from a company’s products or services.
2. Investing activities include any sources and uses of cash from a company’s investments such as a purchase or sale of an asset.
3. Cash from financing activities includes the sources of cash from investors or banks, as well as the uses of cash paid to shareholders. The payment of dividends, the payments for stock repurchases, and the repayment of debt principal (loans) are included in this category.

Example of Company Appropriations

Below is the cash flow statement for Exxon Mobil Corporation (XOM) from Sept 30, 2018, as reported in its 10Q filing. The cash flow statement shows how the executive management of Exxon appropriated the company’s cash and profits:

• Under the investing activities section (highlighted in red), $13.48 billion was allocated to purchase fixed assets or property, plant, and equipment.
• Under the financing activities section (highlighted in green), cash was allocated to pay down short-term debt in the amount of $4.279 billion.
• Also under financing activities, dividends were paid to shareholders (highlighted in blue), which totaled $10.296 billion.

Whether Exxon’s use of cash is effective or not is up to investors and analysts to debate since evaluating the process of appropriating cash is highly subjective. Some investors might want more money allocated to dividends while other investors might want Exxon to allocate money towards investing in the future of the company by purchasing and upgrading equipment.

Appropriations vs. Appropriated Retained Earnings

Appropriated retained earnings are retained earnings (RE) that are specified by the board of directors for a particular use. Retained earnings are the amount of profit left over after a company has paid out dividends. Retained earnings accumulate over time similar to a savings account whereby the funds are used at a later date.

Appropriated retained earnings can be used for many purposes, including acquisitions, debt reduction, stock buybacks, and R&D. There may be more than one appropriated retained earnings accounts simultaneously. Typically, appropriated retained earnings are used only to indicate to outsiders the intention of management to use the funds for some purpose. Appropriation is the use of cash by a company showing how money is allocated and appropriated retained earnings outlines the specific use of that cash by the board of directors.

Limitations of an Appropriation

For investors, the cash flow statement reflects a company’s financial health since typically the more cash that’s available for business operations, the better. However, there are limitations to analyzing how money is spent. An investor won’t know if the purchase of a fixed asset, for example, is a good decision until the company begins to generate revenue from the asset.

As a result, the investor can only infer whether the management is effectively deploying or appropriating its funds properly. Sometimes a negative cash flow results from a company’s growth strategy in the form of expanding its operations.

By studying how a company allocates its spending and uses its cash, an investor can get a clear picture of how much cash a company generates and gain a solid understanding of the financial well being of a company.