Abnormal returns occur when a stock's actual return is greater than its expected return. Calculating an abnormal return is relatively easy. The expected return is determined by overall market performance as well as the beta of the stock.
1. Record a stock price increase as a percentage gain. To do this, simply divide the dollar gain by the original stock price. For example, if a stock price rises from $25 to $27, that constitutes a $2 gain. The percentage gain is two divided by 25, which is 8 percent.
2. Record the corresponding S&P 500 price change over the same time period. The S&P 500 is used because it is generally considered to be the index that most closely approximates the market at large.
3. Determine the stock’s beta. Beta is a measurement of how volatile a stock is in relation to overall market volatility. A beta of 1 means that a stock is expected to perform equal to what the market does. If beta is less than 1, the stock is expected to have lower returns and losses than the market, while a beta greater than 1 indicates higher expected returns and losses. The easiest way to find a stock's beta is to look it up on a financial website.
4. Compare the stock price movement to the S&P 500 price movement. For this example, assume a stock has a beta of 1 and the S&P 500 increased 5 percent over the time that the stock increased by 8 percent. In this example, the stock yielded an abnormal return of 3 percent. The beta of 1 suggests an expected return equal to that of the market (5 percent), but the stock outperformed the market by 3 percent.
Items you will need
- Stock prices
- S&P 500 prices
- Stock beta
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