The Investment Power of Annualization
When choosing between two similar companies to invest in, the most straight-forward method is to compare their financial numbers.
But as I learned the hard way on a final exam many years ago, sometimes things aren’t as simple as they appear. You want to make sure that you are comparing two numbers on the same scale. Otherwise the numbers can mislead you.
The saying you can’t compare apples and oranges may be a cliché, but it’s true.
Today we will discuss a useful method that will hopefully help you in your investing efforts.
Consider This Question
Company A has increased sales 30% in the last three years and Company B has increased it 20% in the last two. Which one is growing at a faster rate?
Easy, right? Aren’t both growing at the same rate—10% per year?
Not quite. If you said 10% you forgot about compounding.
If a company started out with $1 million in yearly sales, and increased sales at 10% over each of the next three years, at the end of each year its sales for that year would be:
Year 1: $1.1 million
Year 2: $1.21 million
Year 3: $1.331 million
Put another way, a company growing at 10% a year would have grown 21% after two years and 33.1% after three years.
So neither A nor B are growing at 10%, but who’s growing faster?
How to Annualize
To answer the question, we need to put the two companies’ growth rates on the same scale. We need to annualize.
As we’ve seen, to account for compounding you can’t just divide the return by the number of years. You will need Excel or a calculator that can exponentially calculate the correct annualized growth rate.
You need to use the following formula:
Annualized Return = Total Return^(1/N)
N = number of years
Note that to properly do the calculation, you need to convert the percentage return into decimal form. Divide the percentage return by 100 and then add 1. Thus, a 30% return is expressed as 1.30 and a 20% return as 1.20.
Now plug in the numbers to figure out their annualized returns.
For Company A: 1.30^(1/3) = 1.091, or 9.1%
For Company B: 1.20^(1/2) = 1.095, or 9.5%
By putting the two numbers on the same scale, we see that Company B is growing at a faster annual rate.
Another Way Annualization Works
What about when the data you have is less than a year? How would you annualize that?
The good news is that the formula still works! You just have to tweak it a bit.
Let’s say you buy a CD that pays 2% interest per year, and compounds interest monthly. If you invest $1,000, how much would you have at the year of the year?
Since there are 12 months in a year, this means every month you earned 0.167% (2%/12) interest. Expressed in decimal, that’s 0.00167. Add 1 and raise to the power of 12.
(1+(0.02/12))^12 = 1.0202
Multiply this by your original 1,000 and you get $1,020.20.
Thus, the total interest you earned over the year is $20.20, or 2.02%.
This 2.02% is also called the annual percentage yield, or APY, the actual interest you receive in a year.
The APY also applies when you are the borrower. The difference the APY is the rate you pay per year.
These are just two ways an investor can apply annualization. There are many other ways annualization can come in handy.
Another way is to annualize the returns you have made in a short period of time to estimate how much return you may achieve in a year. The key is to keep the winners coming and avoid big losses if possible. The profits can really add up over time.
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