What Is Expected Return and How to Calculate It?

Expected return is a concept in finance, providing an estimated future profit or loss on an investment. It is a forward-looking projection, guiding investors in their decision-making. Unlike guaranteed outcomes, expected return is a probabilistic estimate, reflecting the potential average return over time.

Understanding Expected Return

Expected return represents the anticipated profit or loss an investor expects to receive from an investment. It is a probabilistic measure, considering various possible outcomes and their likelihoods to arrive at an average. This differs from historical return, which refers to the actual past performance of an investment. Historical returns are realized results, whereas expected returns are future projections.

Expected return calculations account for potential capital appreciation, an increase in value, and any income generated, such as dividends or interest payments. For example, a stock might offer price appreciation and regular dividends. A bond provides interest payments. These components contribute to the anticipated total return.

Expected return is not a guarantee of future performance. It is a prediction based on available data, acknowledging that actual outcomes can vary due to market volatility, economic shifts, or company-specific events. While historical data informs calculations, past performance does not assure similar future results. Investors consider expected return a guiding estimate, not a definite forecast.

Methods for Calculating Expected Return

Several methods exist for calculating expected return, each with its own approach to forecasting future performance. These methods range from simple averages of past data to more complex models incorporating probabilities and market analysis.

Historical Average Method

The historical average method estimates future returns by analyzing past performance data. This approach involves calculating the arithmetic average of an investment’s returns over a specific period. For example, if a stock had annual returns of 10%, 5%, and 15% over three years, its historical average return would be 10%. This method is straightforward, but its primary assumption is that past performance indicates future results. This may not hold true in dynamic market conditions, as economic cycles, technological advancements, and regulatory changes can cause future returns to diverge from historical averages.

Probability-Weighted Method

The probability-weighted method assigns probabilities to different possible future scenarios and their corresponding returns. This approach provides a nuanced estimate by considering various economic conditions, such as a boom, normal growth, or recession, and the expected return under each scenario. For instance, an investment might have a 40% chance of a 25% gain in a strong market and a 60% chance of a 10% loss in a weak market. The expected return is calculated by multiplying the return of each scenario by its probability and summing these products. This method acknowledges the uncertainty of future outcomes by weighting each potential return by its likelihood.

Analyst Forecast Method

Market analysts and economists publish forecasts for various assets and market segments. These forecasts serve as inputs for estimating expected returns. Analysts use a combination of quantitative models, industry knowledge, and qualitative assessments for their projections. Investors can incorporate these expert opinions into their expected return calculations, especially when specific, forward-looking data is limited. Analyst forecasts offer insights, but potential biases or differing methodologies among analysts should be considered.

Valuation Model Inputs

Certain financial valuation models provide an expected return based on an asset’s current price and anticipated future cash flows. For example, the Dividend Discount Model (DDM) calculates a stock’s intrinsic value based on the present value of its expected future dividends. Rearranging the DDM formula allows one to infer the expected return an investor requires given the stock’s current price and expected dividend growth. The earnings yield (earnings per share divided by stock price) can also be used as a proxy for expected return, especially for companies that reinvest most earnings rather than paying dividends. These models connect an asset’s market price to its value, providing a forward-looking expected return.

Practical Applications of Expected Return

Expected return is used in various financial applications, guiding investors and financial professionals in making informed decisions. It encompasses strategic planning and performance assessment.

Investment Decision Making

Investors use expected return to evaluate and compare potential investment opportunities. By estimating the expected return of different assets, individuals can assess which investments are likely to offer favorable outcomes relative to their objectives. This comparison helps in allocating capital effectively, allowing investors to prioritize assets that align with their profit goals. For example, when choosing between two stocks, an investor might prefer the one with a higher expected return, assuming similar risk profiles.

Portfolio Construction

Expected return plays a role in constructing diversified investment portfolios. It is considered alongside an investor’s risk tolerance and financial objectives to determine asset allocation. Portfolio managers combine various investments with different expected returns and risk characteristics to achieve a desired overall portfolio return while managing risk. The expected return for an entire portfolio is a weighted average of its individual components, with each asset’s weight determined by its proportion of the total portfolio value.

Valuation Analysis

Expected return is an input in financial valuation models, such as discounted cash flow (DCF) analysis. In DCF, future cash flows from an investment are projected and discounted back to their present value using a discount rate. This discount rate reflects the expected return an investor requires for taking on the investment’s risk. Using an appropriate expected return as the discount rate, analysts determine an asset’s intrinsic value, providing a basis for investment decisions. A higher expected return implies a higher discount rate, which leads to a lower present value for future cash flows.

Performance Benchmarking

Expected return serves as a target or benchmark against which the actual performance of an investment or portfolio is measured. Investors set an expected return at the outset of an investment period and compare realized returns to this expectation. This comparison helps assess whether the investment strategy was successful and if actual returns met initial projections. If actual returns fall short of the expected return, it prompts an evaluation of the investment’s underlying assumptions or the market conditions that influenced performance.