Avg. Returns Versus Compounded Returns

When comparing investments, you can use average return or compound return as a comparison method. Compound return is more suitable for comparison and can be plugged into a formula for growth because it uses the power rule. Average return is easier to calculate, but is not commonly used by analysts to review earnings growth.

The calculations

Applying these calculations to earnings is simple. First, you acquire the earnings data for all periods whether it be annual or quarterly earnings data. Then you calculate the rate of return for each period. You would then sum the rates of return and divide that number by the number of periods. This calculates the average earnings growth.

Compounded growth, on the other hand, is a little different. For a compounded growth calculation you get the first period and the last period, divide that number to find a ratio, and take the inverse of the power function by the number of periods.

Average return example

Take for example, company xyz. Let's assume their earnings per share is as follows: $1.00; $2.25; $2.50. The rates of earnings growth for each period would be as follows: (2.25/1-1);(2.5/2.25-1). That equals to 125% growth from current to year one and 11% growth from year one to year two. The average earnings growth, therefore, is equal to (1.25+.11)/2=68%. Notice, from looking at the numbers, you can see a deceleration of earnings growth from year two going into year three. The average earnings growth does not account for rate of change well which makes a big difference in estimation when analyzing many periods.

Compound return example

Now for compounded growth, formulate the problem as follows: (2.5/1)^(1/2)-1=1.58-1=58%. Note the calculation found the compounded growth rate to be 58%, and that it is less than the average growth rate of 68%. Notice that the compound return method intuitively takes into account the deceleration of earnings growth. This is very important when dealing with a many number of periods, especially when analyzing quarterly periods because of the acceleration and deceleration of growth involved and changing of trajectory.

The compounded growth method is more commonly used. Unless the numbers are showing a linear pattern, the average return would function just fine. However, most of the time, growth accelerates and decelerates. When analyzing growth, it is not easy to factor this dimension in without first using the compounded growth method. Note that just a minor difference in growth rate may not seem like a big difference; however, the compounded growth method will estimate earnings or whatever financial measure much better than the average return method.

Be sure also to chart the growth figures to approximate the shape of the growth curve and also approximate a growth formula to best estimate future earnings. After all, most of this is for the purpose of predicting future earnings as well as gauging current growth patterns.