Meaning Of Annualize

An investor can select the best financial instrument by measuring its annual return. Similarly, a company can predict the annual growth of its business over the next year. However, the resulting annualized rate is still an estimate that is subject to change. When converting a short-term return on investment into a long-term return on investment, annualization takes into account compoundingCompoundingCompounding is a method of investing in which the income generated by an investment is reinvested, and the new principal amount is increased by the amount of income reinvested. Depending on the time period of deposit, interest is added to the principal amount.read more and dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more in addition to interest rates.

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Annualize (wallstreetmojo.com)

Key Takeaways

  • Annualize is a predictive analysis tool for understanding the annual worth of an investment with a partial or short-term rate of return.Corporations use annualization to analyze their returns on assets and business growth percentages for the following year.Besides interest rates, the annualization of a short-term return on investment considers compounding and dividends when converting it into a long-term return on investment.Annualization evaluates the corporate financial performance, calculates the loan fees and effective rate of interest, and plans annual taxes, among other things.

How To Annualize?

Annualization applies to investments giving semi-monthly, monthly, quarterly, or semi-annual rates of return. That way, it becomes instrumental in actuarial valuation, borrowing, and investment-related decisions. An investor always remains interested in knowing how much its money will grow each year. Similarly, a corporation must forecast its annual results.

To annualize a return for a shorter duration, multiply it by the number of periods equivalent to one year. For example, the annualized rate of return for one month would be multiplied by 12 months or one quarter by four quarters. Below are the formulas for annualizing the rate of returnAnnualizing The Rate Of ReturnThe annualized rate of return is the percentage of return an investment provides yearly. It serves as a basis for comparison when the rate of return on short-term investments (i.e., the ones made for less than a year) are annualized.read more for short-term durations:

#1 – Quarterly Data

Annualized Rate of Return (ARR) for Quarterly Investment = [Value for One Quarter] * 4 Quarters

For example – A stock gives a return of 10% in the Q1, so its annualized return can using the formula mentioned above will be –

ARR = [10%] * 4 = 40%

#2 – Monthly Returns

ARR for Monthly Investment = [Value for X month] * 12 months

For example – If the same stock gives a return of 3% in one month, so its annualized return can using the formula mentioned above will be –

ARR = [3%] * 12 = 36%

#3 – Annualize A Percentage

i. When the annual rate of returns is available for each year

ARR for An Investment That Compounds = {(1+periodic rate of return) * (1+periodic rate of return)….. (1/number of periods) – 1} * 100

For example – If the annual rate of returns for a mutual fund are 5%, 10% and 15% for 3 consecutive years, its annualized return for next 3 years can be obtained using the above mentioned formula –

  • ARR = {(1+5%)(1+10%)(1+15%) (1/3) – 1} * 100ARR = {(1.05)(1.10)(1.15) (0.33) – 1} * 100ARR = {(1.328) (0.33) – 1} * 100ARR = {(1.098) – 1} * 100ARR = (0.098) * 100ARR = 9.8%

ARR for An Investment That Receives Dividends = {(End Value of Investment-Start Value of Investment)/Start Value of Investment} * 100

For example – The starting value of a mutual fundMutual FundA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more is $3,000, and it receives a dividend of $600 over one year. Consider the mutual fund is sold for $2,500 after the investment period. Then its total value will be $3,100 ($600 + $2,500). So, the return for the mutual fund for the next three years using the annualize formula mentioned above will be –

  • ARR = {(3,100-3,000)/3,000} * 100ARR = {(100)/3,000} * 100ARR = (0.033) * 100ARR = 3.33%

ii. When the value of returns (not returns) are given for each year

ARR = {(End Value of Investment/Start Value of Investment) (1/number of periods) – 1} * 100

For example – The starting value of a mutual fund is $3,000, and it receives a dividend of $1,000 over 3 years. When the mutual fund is sold at $5,000 after the investment period, its total value becomes $6,000 ($1,000 + $5,000). So, the return for the mutual fund for the next 3 years using the above annualize formula will be –

  • ARR = {(6,000/3,000) (1/3) – 1} * 100ARR = {(2) (0.33) – 1} * 100ARR = {(1.257) – 1} * 100ARR = (0.257) * 100ARR = 25.70%

Example

The annualize process is applicable in many areas, such as:

#1 – Portfolio Performance

Annualizing is a method of calculating the return on any investment, including insurance, shares, mutual funds, and bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more. In addition to forecasting the rate of return, annualization enables a comparison of returns on investment in two or more assets with different durations.

#2 – Corporate Performance

#3- Loan Fees

Much like ARR, financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more use annualized percentage rates (APR) to effectively annualize interest rates and origination fees associated with short-term loan products like credit cards. The APR is a percentage of the loan that the borrower will be paying in the next 12 months. In general, the higher the APR, the higher the fees would be. With the help of this information, a borrower can decide whether to opt for a loan.

#4 – Tax-Payments

#5 – Capital Budgeting

From a commoner to an investment banker, any decision related to investments or budgets will be taken after considering the annualized rate of return. For example, a company can calculate the annual rate of return for an asset in its lifetime and move forward with a more cost-efficient project.

Limitations

Several factors, such as market volatility and global economic uncertainty, may affect the annualized rate of return. Other uncontrollable variables that can make the annual forecast go wrong are natural calamities, recession, macroeconomic factorsMacroeconomic FactorsMacroeconomic factors are those that have a broad impact on the national economy, such as population, income, unemployment, investments, savings, and the rate of inflation, and are monitored by highly professional teams governed by the government or other economists.read more, geopolitics, legal amendments, etc. The COVID-19 pandemic causing a drastic decline in the U.S. GDP in 2020 is an ideal example of how annualization can go wrong.

Financial marketsFinancial MarketsThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more are highly volatile, and things can change in the blink of an eye. An asset that once seemed to have a positive outlook with the annualization method might witness negative growth due to these factors.

This has been a guide to annualize and its meaning. Here we discuss how to annualize along with examples and limitations. You may also learn more from the following articles –

Annualize is a method of measuring the financial performance of a short-term investment over a year. Annualization refers to investments that produce short-term returns for semi-monthly, monthly, or quarterly periods. As a result, it can be applicable in actuarial valuation, borrowing, and investing decisions.

The annualize process can help calculate the return on insurance, stocks, mutual funds, bonds, evaluate a company’s financial performance, compute loan fees, effective loan interest rates, origination fees, manage tax payments, capital budgeting, etc.

  • Annual ReturnAnnual ReturnThe annual return is the income generated on an investment during a year as a percentage of the capital invested and is calculated using the geometric average. This return provides details about the compounded return earned yearly and compares the returns supplied by various investments like stocks, bonds, derivatives, mutual funds, etc.read moreEffective Annual RateEffective Annual RateEffective annual rate (EAR) is the rate actually earned on investment or paid on the loan after compounding over a given period of time and is used to compare financial products with different compounding periods i.e. weekly, monthly, annually, etc. As the compounding periods are increased, the EAR increases. Effective Annual Rate = (1 + i/n)n – 1read moreSimple InterestSimple InterestSimple interest (SI) refers to the percentage of interest charged or yielded on the principal sum for a specific period.read more