There are many methods an investor can use to determine if a stock is a good buy or not. Three indicators often used to assess the risk of a security are beta, alpha and the Sharpe ratio. One of the most popular measures of risk associated with a security is its beta. Beta is a measure of a stock’s volatility in relation to the market as a whole. The market is given a beta of 1. 0 and individual stocks are ranked according to how much they deviate from the market’s beta.
Stocks with a beta of less than 1. 0 are considered less volatile than the market and, therefore, pose less risk.
Stocks that have betas higher than 1. 0 are considered more volatile than the market and, therefore, pose more risk. All things being equal, an investor would expect to see higher returns on a stock with a beta higher than the market than one with a beta lower than the market. (1) Beta is also a key component for the capital asset pricing model (CAPM).
The original CAPM defined risk in terms of volatility, as measured by a stock’s beta coefficient. The formula is: Kc = Rf + beta Km – Rf) where Kc is the risk-adjusted discount rate (also known as the cost of capital)
Rf is the rate of a “risk free” investment, i. e. ten-year treasury bill Km is the return rate of a market benchmark, such as the S&P 500 Kc is the expected rate of return you would require before you would be interested in a particular stock at a particular price. The CAPM expresses the amount of risk a particular stock has and gives an investor an idea of the expected returns he should expect given a certain level of risk. The more risky a stock is the higher the level of returns an investor would expect for that particular stock. (2)
A stock’s alpha is a mathematical estimate of the amount of return expected from a stock’s inherent values, such as the rate of growth of in earnings per share, management strengths or other factors, as opposed to general market conditions. Stocks with an alpha greater than 1. 0 can be expected to outperform the market regardless of what happens to the market as a whole. (3) The Sharpe ratio helps investors determine the best possible proportion of securities to use in a portfolio that can also include cash. The formula for the Sharpe ratio is: S(x) = (Rx – Rf) / StdDev(x) where x is some investment
Rx is the average annual rate of return of x Rf is the best possible rate of return of a “risk free” security (i. e. cash) StdDev is the standard deviation of Rx The Sharpe ratio is a direct measure of reward-to-risk. In other words, the Sharpe ratio is used to characterize how well the return of an asset compensates the investor for the risk taken. (4) Although beta, alpha and the Sharpe ratio are useful for an investor to gauge the risk of a security or portfolio of securities there are also other methods an investor can use to determine whether a security is a good investment or not.
The two most common methods used to determine the investment potential of a security are fundamental analysis and technical analysis. Fundamental analysis is the process of looking at a business from its financial statements. This type of analysis typically looks at various ratios of the business to determine its financial health. The goal of fundamental analysis is determine the current worth of a stock and how the market values the stock. (5) Probably the most two important factors looked at in fundamental analysis are a company’s earnings and revenue growth.
Investors like to see earnings and revenue increasing by at least 25% for each of the last three quarters and year-to-date. Return on equity (ROE) is also a major fundamental factor. ROE reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. (6) The higher a company’s ROE compared to its industry the better. Investors typically look for an ROE of at least 17%. Technical analysis is a method of evaluating stocks by relying on the assumption that market data, such as charts of price, volume and open interest can help predict future market trends.
(7) Investors using technical analysis typically look for trends in chart data and use a variety of technical indicators, such as moving averages, Bollinger bands, fast and slow stochastics, MACD, and RSI to determine the right buy point for a stock. More sophisticated investors use a combination of fundamental analysis and technical analysis to determine whether a stock is a good buy or not. They use fundamental analysis to make sure a company is healthy from a financial standpoint and is a leader in its industry.
Once determining a stock is healthy from a fundamental standpoint, these investors will use technical analysis to determine the correct buy point for a stock. A stock’s chart will show the investor how the stock is actually performing in the market and whether it is rising out of a good base or is overbought based on how far its current price is from its 50 day moving average. If a stock’s price is 30% or more above its 50 day moving average, the risk that it will fall into a correction is greater. References: (1) http://www. investopedia. com/articles/stocks/04/113004.
asp Beta: Know the Risk (2) http://www. moneychimp. com/articles/valuation/capm. htm CAPM Calculator (3) http://www. allbusiness. com/glossaries/alpha/4943389-1. html Business Definition for Alpha (4) http://www. moneychimp. com/articles/risk/sharpe_ratio. htm The Sharpe Ratio (5) http://stocks. about. com/od/evaluatingstocks/a/Fundanatools1. htm Tools of Fundamental Analysis (6) http://beginnersinvest. about. com/cs/investinglessons/l/blreturnequity. htm Return on Equity (ROE) (7) http://www. investorwords. com/4925/technical_analysis. html Technical Analysis