The stock market is an attractive option for some investors, with the possibility of fast, lucrative profits as companies grow and increase their value. But stocks are also highly volatile, which means they have a high likelihood of changing value, representing in many cases a substantial risk. Returns are one way of measuring the performance of a given stock or the stock market as a whole.
Returns, also known as returns on investment, are ratios that represent how much value a stock or group of stocks has gained or lost relative to their price. The basic formula for determining a return is subtracting the initial value from the final value, and dividing the result by the initial value. For example, if you purchased stock for $500 and today it is worth $1,000, your return is 1 (1000-500, divided by 500), or 100%. A negative return represents a loss while a positive return represents a profit.
There are several ways to measure a stock market return. The simplest method is the basic formula based on cost and final value. A more complex method includes factoring in compounded earnings, as when a stockholder reinvests dividend payments to buy additional shares without actually putting more personal money into the stock. Stock market analysts also compute returns on equity, which refers to a business's gain or loss of value relative to the total amount of money stockholders have invested in it, and returns on total assets, which measures how much a business gains or loses relative to the total value of its assets.
Returns are an important measurement of how a corporation or stock market gains or loses value over time. Because returns figure in the value of an investment or the assets of a business, the results can be used to compare both large and small businesses, as well as companies with very different stock prices. In essence, returns measure not only how much money a given stock investment makes, but how much money an investor would have needed to put on the line in order to earn that money. Economists also use historical returns to gauge periodic cycles in the economy and make predictions about the future direction of markets.
Returns are not the only metric stock analysts and investors use to examine the market as a whole or individual corporations. While returns are important, they lack information. For one thing, a return is only relevant for a specific period of time, such as a quarter, month or year. To each investor the only return that matters in the end is the return during the time frame in which they held the stock. Returns also don't take changes in the broader economy into account, which is why analysts compare returns to inflation rates and the performance of other stocks and markets over the same time period. Finally, returns don't incorporate broker fees and taxes, which affect how much an investor actually gains or loses from a given stock investment.
- Stock charts with a gold and silver pen image by Victor Soares from Fotolia.com