Definition
The finance term abnormal return is used to describe the difference between the expected return of an investment and its actual return. Abnormal returns can be either good or bad news for an investor, since the term can be used to designate both higher and lower than expected returns.
Calculation
Abnormal Return = Actual Return - Expected Return
Explanation
While the term abnormal return typically applies to a single security, it can also apply to a portfolio of investments. The expected return is usually based on a valuation tool such as the asset pricing model and / or relative to a benchmark that represents a broad measure of the market's performance such as the S&P 500 Index.
Abnormal returns are frequently a direct result of events such as earnings or dividend announcements, pending lawsuits, and merger activity. These events provide the market with new information, which was not previously reflected in the price of a security.
Example
Company A's stock has a beta equal to 1.0, which means its price should follow the long term trend of the overall market. Earlier in the year, Company A was awarded a large, multi-year contract to provide equipment to a developing nation. As a result of this work, Company A raised its earnings forecast for the next five years.
Over the last twelve months, the price of Company A's stock increased by 8.7%, while the S&P 500 increased by 3.2%. Since Company A's beta is equal to 1.0, the abnormal return for Company A's common stock is calculated as:
= 8.7% - 3.2%, or 5.5%
Related Terms
- The financial metric return on assets, or ROA, is a profitability ratio that analyzes management's ability to earn a fair return on the money invested in the assets of a company. Only two variables are required to determine return on assets: net income and total assets.
Moneyzine EditorNovember 6th, 2024 - The financial metric return on equity, or ROE, is a profitability ratio that analyzes management's ability to earn a fair return on the shareholders' investment. Only two variables are required to determine return on equity: net income and stockholder's equity.Moneyzine EditorNovember 6th, 2024
- The term return on investment, or ROI, is used to describe a number of financial metrics that are used to measure the profitability of a company. All of the return on investment metrics use variables found on both the income statement and balance sheet.Moneyzine EditorNovember 6th, 2024
- The term revenue margin of safety refers to a calculation the investor-analyst can use to determine how much revenues can decline before the break-even point is reached. The revenue margin of safety is important to understand when a company has relatively few, but large, customers.Moneyzine EditorNovember 6th, 2024
- The term revenue break-even point describes a calculation analysts can use to determine the level of revenues at which a company remains profitable. The higher a company's actual revenues are above their break-even point, the higher is their potential profitability.Moneyzine EditorNovember 6th, 2024
- The term operating assets ratio refers to a calculation used to determine the proportion of assets that can be eliminated without impairing operating capacity. A relatively high operating assets ratio is indicative of a business that efficiently uses its capital resources.Moneyzine EditorSeptember 20th, 2023
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