An explanation of Compound Annual Return (CAR) as used in myICLUB.com

This FAQ is broken into three main parts:

• A relatively simple explanation for how the CAR figures are calculated
• A more detailed explanation
• Examples of situations where the CAR results can be confusing, even when accurate.

The Simple Part -The myICLUB CAR calculations use financial industry standard Internal Rate of Return (IRR) calculations. IRR calculation take into account not only the amount of an investment but also the time period of the investment. In this way it can differentiate the same total amount invested as single large amount from multiple smaller investments made over a time period. A simple way to think of this is using the concept of dollar-years for an investment. A dollar-year would be one dollar invested for one year. Here is an example. One thousand dollars is invested on the first of the year. At the end of the year the investment is worth $1,100. You had 1000 dollar-years of investment. To have a final value of $1,100 at the end of one year, the return rate would be 10% per year. Compare this to investing $500 at the beginning of the year and another $500 after 6 months. The total dollar-years invested is then (500 x 1 year) + (500 x 0.5 years) = 750 dollar-years. For this investment to be worth $1,100 at the end of the year, the CAR must be higher than 10% as the total dollar-years of investment is less than the previous example. The CAR for this investment is actually about 13.333%. The CAR figures in myICLUB are a bit more complex as they take into account all cash flows into and out of an investment. These would include additions to a position, distributions received such as dividends and return of capital, and the sale of partial positions in the investment.

The Complex Part – The IRR calculations are especially complex when the cash flow amounts are not always the same and timing between cash flows are not the same. This is the case for investment club investments in their portfolio components. The Internal Rate of Return is defined as that rate in which the sum of the Present Value (PV) of all cash flows related to an investment equal zero. For this to work, cash invested into an investment is considered a negative cash flow while cash received back is a positive cash flow. The final cash flow is a positive one for the present market value of the asset. This would be the market value on a Valuation Statement on the valuation date. This is an iterative process. A guess rate is used and if not correct, the rate is adjusted up or down as appropriate and the calculations done again. This continues until a rate is found that meets the conditions. For the adventurous, there is a spreadsheet function that will do this for you. It is the XIRR function (in Excel at least). There are 3 inputs for this function. The first is a list of the dates of all the cash flows, the next is the amount of all the cash flows. Remember, flows into the investment are negative and flows back to the investor are positive. The order of the dates and amounts must match. The final variable to input is a guess rate. Usually, 0.1 is a good starting point.

If you are comfortable with Excel, make a 2 column by X row table. One column for dates, and the other column for amounts. The date and amount of a cash flow will be on the same row. The number of cash flows determines the number of rows. Then choose a row range from the dates column and amounts column for the appropriate XIRR variables fields. To find the dates and amounts of cash flows look to the Security Ledger for a stock to see all the cash flows.

The Possibly Confusing Parts –  There are certain situations where the CAR figures can be confusing even when accurate. It is important to remember the ANNUAL part the myICLUB Compound Annual Return calculations. These calculations can be confusing and not very useful when the total holding period is short, that is, less than a year. In those cases, the CAR is more of a projection of what the annual return would be, IF the stock performs just as well for a whole year as it performed for the short period held. It is common for CAR figures in the hundreds of percent, even over a thousand, if a stock makes a sudden upturn in the month or two after purchase. Conversely, a drop in price shortly after purchase may give a  -100% CAR. The closer you get to holding the security for one year, the more useful and less confusing the CAR figures will be.

The next confusing situation is when you acquire a security via a spinoff or merger. The default initial cash flow details for these situations is the transaction completion date with the amount the fair market value (FMV) of the security received. The CAR figures then represent how the FMV has changed since the transaction completion date. The confusing part comes when members compare the CAR to the gain or loss for this security. It is possible for the cost basis to be less than the market value, an unrealized gain, and the CAR to be negative. This happens when the FMV of the security has decreased since acquisition but has not yet decreased below the cost basis transferred to this security in the merger or spinoff. The opposite can also be true. The CAR can be positive since the FMV has increased since acquisition but has not increased enough to be greater than the cost basis. The security is in an unrealized loss condition even though the CAR is positive. There is a myICLUB setting that will use the cost basis rather than the FMV as the initial cash flow amount. This can be changed using the Update club settings link in the Utilities section. We do not recommend changing from the default FMV setting. Using the cost basis alternative will not track the performance of the stock since the club acquired it. Instead, the past performance of the non-surviving company in a merger or parent company in a spinoff will skew the CAR of the holding received in the  merger or spinoff transaction. Keep the default if you want to track how the company has performed since it was acquired.

The final situation that can cause confusion is when a club repurchases a company that it previously held but had completely liquidated before repurchase. The default setting is to not include the previous ownership cash flows in the CAR calculations. The reason is the same as above for mergers and spinoffs. By not including the previous ownership positions the CAR figures will show how the stock has performed in the most recent holding period. If the alternative to include earlier ownership is used, the CAR will not give the performance of only the current position. The past performance of now fully liquidated positions in the stock will skew the CAR away from the performance of the current position.