Abnormal Return

Definition

The finance term abnormal return is used to describe the difference between the expected return of an investment and its actual return.  Abnormal returns can be either good or bad news for an investor, since the term can be used to designate both higher and lower than expected returns.

Calculation

Abnormal Return = Actual Return - Expected Return

Explanation

While the term abnormal return typically applies to a single security, it can also apply to a portfolio of investments.  The expected return is usually based on a valuation tool such as the asset pricing model and / or relative to a benchmark that represents a broad measure of the market's performance such as the S&P 500 Index.

Abnormal returns are frequently a direct result of events such as earnings or dividend announcements, pending lawsuits, and merger activity.  These events provide the market with new information, which was not previously reflected in the price of a security.

Example

Company A's stock has a beta equal to 1.0, which means its price should follow the long term trend of the overall market.  Earlier in the year, Company A was awarded a large, multi-year contract to provide equipment to a developing nation.  As a result of this work, Company A raised its earnings forecast for the next five years.

Over the last twelve months, the price of Company A's stock increased by 8.7%, while the S&P 500 increased by 3.2%.  Since Company A's beta is equal to 1.0, the abnormal return for Company A's common stock is calculated as:

= 8.7% - 3.2%, or 5.5%

Related Terms

return on assets, return on equity, return on investment, revenue margin of safety, revenue break-even point, operating assets ratio