Raw vs adjusted prices (tutorial #4)

The previous posts on total returns and stock splits make it clear that we cannot calculate stock returns accurately using changes in raw prices. Luckily, data on adjusted prices that take into account dividends and stock splits is available free on the internet through Yahoo! Finance.

Adjusted prices make life much easier when calculating returns. Let's say you have monthly raw and adjusted price data on General Electric's common stock between 1990 and 2010, and you would like to calculate the monthly returns on this stock over this sample period. You can't really use raw prices to calculate returns, since (i) General Electric has been paying dividend regularly, (ii) the company's stock was split a few times within the sample period. In other words, you can't use the total return formula based on raw prices:

R_t = ( D_t + P_t - P_t-1 ) / P_t-1

unless you have complete data on dividend payments D_t and stock splits. But, you can use the following formula based on adjusted prices:

R_t = ( P_t^a - P_t-1^a ) / P_t-1^a

where the superscript a signifies that the price is adjusted. For instance, if a stock's adjusted prices at the start and at the end of January were $10 and $11 respectively, you can safely say that the stock's return in January was ($11 - $10) / $10 = 10%, without worrying about whether there was a dividend payment or a stock split during the month.

Next tutorial: Dollar vs rate of return
Previous tutorial: Stock splits

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