Question

11) Suppose you used the monthly “close” price instead of “adjusted close” price. How would the average monthly returns change? What would this depend on?

Answer 1

Answer 11:-

Firstly, we need to understand what Adjusted Closing Price mean. So, Adjusted closing price makes an amendment in a stock's closing price in order to reflect the stock's real value after taking into account any corporate actions which is taken by the company. It is assumed that adjusted closing price reflects the true price of a stock and is often used when examining historical returns or at the time of performing a detailed analysis of historical returns.

In contrast to that, the Closing price is considered as the 'raw' price which just reflects the cash value of the stock depending upon the last transacted price before the market closes. When trading hours got completed on any given day on a stock exchange, all the stocks are priced at closing price. This price is the price of the last lot of stock that was traded on that given day which is referred to as the stock's closing price.This price is often used as a reference point by many investors in order to compare a stock's performance over a given period of time.

But there are some flaws which are related to Stock's Closing price, which are:-

• The Stock's closing price (of any company) usually doesn't reflect any news which is released by the company on that day. Major announcements done by any company which can be related to earnings, stock splits, reverse stock splits, and stock dividends are generally released after the close of the regular trading day in order to provide traders/nvestors a chance to digest the news before acting on it. The release of news generally causes a stock's price to move significantly upwards or downwards which makes these prices swing up or down.
• Some corporate actions, such as stock splits, dividends / distributions and rights offerings, affect a stock's price and it is not reflected in the Closing price.

However, these adjustments are very much essential in order to arrive at a technically accurate reflection of the true value of the stock. Adjusted Closing Price is useful during examining the historical returns of any stock because it gives an technicafairlly  representation of the company's equity value.

Adjusted Closing Price and its Inclusions:-

Effect of New Offerings-

New offerings generally decrease the value of existing share price as there are more number of individual shares, with every new offering every share represents a smaller amount of what is used to reflect earlier.

Example:- A stock have a closing price of $100 per share, but if the company has issued new offerings, so maybe now each stock might only be worth of mere $80 and this will depend on the number of new offering.

Effect of Stock Splits-

When individual stock price becomes very expensive, in such a case companies usually split the stocks of the company into smaller units. These splits, decreases the overall value of each stock as the number of total stocks increases.

Example:- A company with 20,000 shares of $100 stocks split their stocks into half, so now there are 40,000 shares. Each of the 40,000 shares are now worth of $50. When these stock worth $50 will be bought up in the stock market, then its price will rise a bit. So, Adjusted closing price takes into account the decrease in value caused by the split and also the subsequent possible increase in value.

Effect of Dividends:-

Dividends are payouts that a company distributes to its stockholders when profits of the company are appreciating. Dividend can be given as an award of additional shares to the existing stockholder or in the form of cash dividend. These dividends actually decrease the value of the stock. This decrease is because dividens pay-out reduces the value of the company as the company transfers the money or stocks in the hands of stockholders.

Example:- A company declared a cash dividend of $5 and is trading at $55 per share on the ex-dividend date. On the ex-dividend date, the stock price gets reduced by $5 and the adjusted closing price is $50.

Closing Prices does not reflect any of the above mentioned effects.

Conclusion:- The adjusted closing price gives a better idea of the overall technical fair value of the stock and it helps in making informed decisions regarding buying and selling. In contrast to that, the closing stock price only tells the exact cash value of a stock at the end of any given trading day.