Expected return is simply an estimate of how an investment will perform in the future. Investment analysts formulate expected returns by examining the historical performance of the stock during different economic cycles, and arrive at an expectation based on the stock's return during similar economic cycles. Another way of developing an expected return figure is to apply probabilities to different company performance scenarios within different economic scenarios.
Elements of Return
Return on an investment is the total value derived from that investment over a specified period of time. Actual return consists of the profit or loss made when the stock is sold plus whatever dividend income is received during the time the stock was held. If the stock pays no dividend, return is simply positive or negative depending on whether the stock was sold for more or less than its cost. Return is arrived at by dividing the total return by the cost of the investment. Expected return is an estimation of future return.
Affect on Stock Price
The price performance of a stock is based on the company earnings. If the average market price-earnings ratio for stocks in that industry is 20 times earnings, and earnings come in at $1 per share, the stock should trade at $20 a share. If the company announces a big contract, analysts will estimate future earnings based on the value of the contract. If the contract is expected to add $0.50 to earnings, the stock will begin trading at a price that discounts or anticipates an earnings announcement of $1.50 per share. In that case, the stock can be expected to move up in price to $30 per share.
Analysts look at past earnings increases to see if the dividend is likely to be increased as a result of higher earnings. When interest rates are low, price earnings ratios expand. That is because investors move out of bonds seeking better returns on stock. This increases demand for stock and the price of the stock rises relative to its earnings. Also, low interest rates are thought to benefit earnings, so investors are expecting future earnings increases. When interest rates are high, investors move out of stocks into bonds, and average price-earnings ratios contract. Analysts take all this into account when looking at a stock's historical performance and the return that can be expected.
Some investors and analysts consider past performance a risky way to estimate future return. They consider the probability that interest rates will rise or fall and the likelihood that something will disrupt the business of the company, causing the company's earnings to be lower than expected. They create business and economic scenarios and estimate the company's return according to the most likely scenario, estimate any fluctuations in the market price-earnings ratio for companies in that industry and how it will affect the price performance of the stock.
- New York University Stern School of Business: Expected Return, Realized Return and Asset Pricing Tests
- University of Chicago Booth School of Business: Predicting Stock Price Movements from Past Returns: The Role of Consistency and Tax-Loss Selling
- Columbia University: Risk and Return -- Expected Return
- Dimensional Fund Advisors: Earnings Growth and Stock Returns
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