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Budgeting Money Buying & Selling Stock Stock Market Investing How do I Evaluate the Performance of Stock Market Investments?

## budgeting moneyDriven by Demand Media

How do I Evaluate the Performance of Stock Market Investments?
by David Ingram, Demand Media

Share RSS Email Stock market investments can provide profitable opportunities for experienced traders as well as beginners. Any profit made on stock investments is desirable, but knowing how to evaluate the performance of stock market investments can help you to ascertain which investments' performance stands above the rest.

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Step 1
Analyze a stock's earnings per share (EPS). EPS serves as a measure of how much of a company's net income can be allocated to each share of stock. Stock traders watch changes in EPS closely and respond quickly. If a stock's EPS is significantly higher than its stock price it can be considered a solid investment, since it is likely that the stock's value will increase in the future. Use the following formula to calculate EPS: EPS = (net income preferred stock dividends) / number of shares outstanding. For example, if a company's net earnings after dividends is $50 million and the company has 10 million shares of stock outstanding, EPS would work out to$5.00. If the stock price was currently $3.75, investors could expect the price to edge close to the$5.00 level. No Matches Found. Please try your search again.

Step 2
Calculate the dividend payout ratio to gain insight into a stock's dividend performance. The dividend payout ratio compares dividends per share to EPS. The higher the payout ratio, the more money the company invests in dividend payments rather than expansion. Companies with lower payout ratios should experience stronger earnings growth. Use the following formula for the payout ratio: Payout Ratio = (total dividends / number of shares outstanding) / EPS

Step 3
Calculate a stock's price/earnings (P/E) ratio, and compare it to others in the same industry. The P/E ratio compares a stock's market price to its EPS. As mentioned above, a market price lower than EPS can generally be expected to rise, and the opposite holds true as well. Thus, a P/E under 1 indicates growth opportunity, while a P/E over 1 indicates an inflated price likely to drop.

Use the following formula to calculate P/E: P/E = market price / EPS

Step 4
Analyze stocks' return on investment (ROI). ROI is a simple tool that can be used after you've sold a particular stock holding. ROI compares the total income generated by an investment to the capital outlay required up front. Use the following formula to calculate ROI: ROI = (gains cost) / cost For example, if you purchased 100 shares of stock for a total of $300 and sold them for a total of$400, the ROI would be close to 33 percent.

Step 5
Use stock charting tools to get a glance at a stock's performance over any period of time. Use technical indicators, such as 20- and 50-day moving averages, to predict price shifts in the near future. Charts can give you insight into a stock's daily trading volume in addition to showing a history of its market prices. Stocks with long trends of gradual price increases can be better suited to longterm investments, while those with quick, dramatic fluctuations can be better plays for day-trading.

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## Long Term Stocks to Buy

Tip

Stock news websites, such as Bloomberg.com and MSN Moneycentral, can display a range of performance ratios at a glance for any listed company, along with industry and company averages. Some even go as far as to compare ratios to a company's largest competitors.

References

Bay Area Bulls Investment Club: Key Financial Ratios University of Notre Dame: Financial Ratio Explanations Stock Trading to Go: Stock Charts -- Understanding the Basics

David Ingram has written for multiple publications since 2009, including "The Houston Chronicle" and online at Business.com. As a small-business owner, Ingram regularly confronts modern issues in management, marketing, finance and business law. He has earned a Bachelor of Arts in management from Walsh University.

This article may be too technical for most readers to understand. Please help improve this article to make it understandable to non-experts, without removing the technical details. The talk page may contain suggestions. (July 2013) In finance, the beta () of an investment is a measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors. The market portfolio of all investable assets has a beta of exactly 1. A beta below 1 can indicate either an investment with lower volatility than the market, or a volatile investment whose price movements are not highly correlated with the market. An example of the first is a treasury bill, the price does not go up or down a lot, so it has a low beta. An example of the second is gold. The price of gold does go up and down a lot, but not in the same direction or at the same time as the market.[1]

A beta above one generally means both that the asset is volatile and tends to move up and down with the market. An example is a stock in a big technology company. Negative betas are possible for investments that tend to go down when the market goes up, and vice versa. There are few fundamental investments with consistent and significant negative betas, but some derivatives like equity put options can have large negative betas.[2]

Beta is important because it measures the risk of an investment that cannot be diversified away. It does not measure the risk of an investment held on a stand-alone basis, but the amount of risk the investment adds to an already-diversified portfolio. In the Capital Asset Pricing Model, beta risk is the only kind of risk for which investors should receive an expected return higher than the risk-free rate of interest.[3]

The definition above covers only theoretical beta. The term is used in many related ways in finance. For example, the betas commonly quoted in mutual fund analyses generally measure the risk of the fund arising from exposure to a benchmark for the fund, rather than from exposure to the entire market portfolio. Thus they measure the amount of risk the fund adds to a diversified portfolio of funds of the same type, rather than to a portfolio diversified among all fund types.[4]

Beta decay refers to the tendency for a company with a high beta coefficient to have its beta coefficient normalize[disambiguation needed] to the market beta. It is an example of regression toward the mean.

Contents [hide] 1 Definition 1.1 Security market line 2 Choice of benchmark 3 Investing 4 Academic theory 5 Multiple beta model 6 Estimation of beta 7 Interpretations of Beta 8 Extreme and interesting cases 9 Criticism 10 See also 11 References 12 External links Definition Beta is computed by some linear regression. Given an asset and a benchmark that we are interested in, we want to find an approximate formula

r_a \approx \alpha + \beta r_b where ra is the return of the asset and rb is return of the benchmark.

## More precisely we put

r_{a,t} = \alpha + \beta r_{b,t} + \varepsilon_t where t is an error term (the unexplained return). Click here for a definition of Alpha ().

The right and are those such that t2 is as small as possible (least squares).

Solving the regression See also: Linear regression Many calculators can do linear regression.

## Some formulas A common expression for beta is

\beta = \frac {\mathrm{Cov}(r_a,r_b)}{\mathrm{Var}(r_b)} where Cov and Var are the covariance and variance operators.

## This can also be expressed as

\beta = \rho_{a,b}(\sigma_a/\sigma_b) where a,b is the correlation of the two returns, and a and b are the respective volatilities.

a=*Var(ra)+, b=*Var(rb)+, a,b=Cov(ra, rb)/*Var(ra)Var(rb)+ From this, we find that beta can be explained as "correlated relative volatility". This has three components:

correlated relative volatility Beta is also referred to as financial elasticity or correlated relative volatility, and can be referred to as a measure of the sensitivity of the asset's returns to market returns, its non-diversifiable risk, its systematic risk, or market risk. On an individual asset level, measuring beta can give clues to

volatility and liquidity in the marketplace. In fund management, measuring beta is thought to separate a manager's skill from his or her willingness to take risk.

The portfolio of interest in the CAPM formulation is the market portfolio that contains all risky assets, and so the rb terms in the formula are replaced by rm, the rate of return of the market. The regression line is then called the security characteristic line (SCL).

\mathrm{SCL}: r_{a,t} = \alpha_a + \beta_a r_{m,t} + \varepsilon_{a,t} \alpha_a is called the asset's alpha and \beta_a is called the asset's beta coefficient. Both coefficients have an important role in modern portfolio theory.

For example, in a year where the broad market or benchmark index returns 25% above the risk free rate, suppose two managers gain 50% above the risk free rate. Because this higher return is theoretically possible merely by taking a leveraged position in the broad market to double the beta so it is exactly 2.0, we would expect a skilled portfolio manager to have built the outperforming portfolio with a beta somewhat less than 2, such that the excess return not explained by the beta is positive. If one of the managers' portfolios has an average beta of 3.0, and the other's has a beta of only 1.5, then the CAPM simply states that the extra return of the first manager is not sufficient to compensate us for that manager's risk, whereas the second manager has done more than expected given the risk. Whether investors can expect the second manager to duplicate that performance in future periods is of course a different question.

## Security market line Main article: Security market line

The Security Market Line The SML graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML.

The relationship between and required return is plotted on the security market line (SML) which shows expected return as a function of . The intercept is the nominal risk-free rate available for the market, while the slope is E(Rm) Rf. The security market line can be regarded as representing a

single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the SML is thus:

\mathrm{SML}: E(R_i) - R_f = \beta_i (E(R_M) - R_f).~ It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting a lower return for the amount of risk assumed.

Choice of benchmark In the US, published betas typically use a stock market index such as S&P 500 as a benchmark. The S&P 500 is a popular index of U.S. large-cap stocks. This has some shortcomings, it is U.S., it is largecap, and it is stocks. Other choices may be an international index such as the MSCI EAFE. The benchmark should be chosen to be similar to the other assets chosen by the investor. The ideal index would match the portfolio; for example, for a person who owns S&P 500 index funds and gold bars, the index would combine the S&P 500 and the price of gold. In practice a standard index is used. The choice of the index need not reflect the portfolio under question; e.g., beta for gold bars compared to the S&P 500 may be low or negative carrying the information that gold does not track stocks and may provide a mechanism for reducing risk. The restriction to stocks as a benchmark is somewhat arbitrary. A model portfolio may be stocks plus bonds. Sometimes the market is defined as "all investable assets" (see Roll's critique); unfortunately, this includes lots of things for which returns may be hard to measure.

Investing By definition, the market itself has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the macro market (for simplicity purposes, the S&P 500 is sometimes used as a proxy for the market as a whole). A stock whose returns vary more than the market's returns over time can have a beta whose absolute value is greater than 1.0 (whether it is, in fact, greater than 0 will depend on the correlation of the stock's returns and the market's returns). A stock whose returns vary less than the market's returns has a beta with an absolute value less than 1.0.

A stock with a beta of 2 has returns that change, on average, by twice the magnitude of the overall market's returns; when the market's return falls or rises by 3%, the stock's return will fall or rise (respectively) by 6% on average. (However, because beta also depends on the correlation of returns, there can be considerable variance about that average; the higher the correlation, the less variance; the lower the correlation, the higher the variance.) Beta can also be negative, meaning the stock's returns tend to move in the opposite direction of the market's returns. A stock with a beta of 3

would see its return decline 9% (on average) when the market's return goes up 3%, and would see its return climb 9% (on average) if the market's return falls by 3%.

Higher-beta stocks tend to be more volatile and therefore riskier, but provide the potential for higher returns. Lower-beta stocks pose less risk but generally offer lower returns. Some have challenged this idea, claiming that the data show little relation between beta and potential reward, or even that lower-beta stocks are both less risky and more profitable (contradicting CAPM).[5] In the same way a stock's beta shows its relation to market shifts, it is also an indicator for required returns on investment (ROI). Given a risk-free rate of 2%, for example, if the market (with a beta of 1) has an expected return of 8%, a stock with a beta of 1.5 should return 11% (= 2% + 1.5(8% 2%)) in accordance with the financial CAPM model.

Academic theory Academic theory claims that higher-risk investments should have higher returns over the long-term. Wall Street has a saying that "higher return requires higher risk", not that a risky investment will automatically do better. Some things may just be poor investments (e.g., playing roulette). Further, highly rational investors should consider correlated volatility (beta) instead of simple volatility (sigma). Theoretically, a negative beta equity is possible; for example, an inverse ETF should have negative beta to the relevant index. Also, a short position should have opposite beta.

This expected return on equity, or equivalently, a firm's cost of equity, can be estimated using the Capital Asset Pricing Model (CAPM). According to the model, the expected return on equity is a function of a firm's equity beta (E) which, in turn, is a function of both leverage and asset risk (A):

## K_{E} = R_F + \beta_E (R_M - R_F) where:

KE = firm's cost of equity RF = risk-free rate (the rate of return on a "risk free investment"; e.g., U.S. Treasury Bonds) RM = return on the market portfolio \beta_E = \beta =\left[ \beta_A - \beta_D \left(\frac {D}{V}\right) \right] \frac {V}{E} because:

## \beta_A = \beta_D \left(\frac {D}{V}\right) + \beta_E \left(\frac {E}{V}\right) and

Firm value (V) + cash and risk-free securities = debt value (D) + equity value (E) An indication of the systematic riskiness attaching to the returns on ordinary shares. It equates to the asset Beta for an ungeared firm, or is adjusted upwards to reflect the extra riskiness of shares in a geared firm., i.e. the Geared Beta.[6]

Multiple beta model The arbitrage pricing theory (APT) has multiple betas in its model. In contrast to the CAPM that has only one risk factor, namely the overall market, APT has multiple risk factors. Each risk factor has a corresponding beta indicating the responsiveness of the asset being priced to that risk factor.

Multiple-factor models contradict CAPM by claiming that some other factors can influence return, therefore one may find two stocks (or funds) with equal beta, but one may be a better investment.

Estimation of beta To estimate beta, one needs a list of returns for the asset and returns for the index; these returns can be daily, weekly or any period. Then one uses standard formulas from linear regression. The slope of the fitted line from the linear least-squares calculation is the estimated Beta. The yintercept is the alpha.

Myron Scholes and Joseph Williams (1977) provided a model for estimating betas from nonsynchronous data.[7]

Beta specifically gives the volatility ratio multiplied by the correlation of the plotted data. To take an extreme example, something may have a beta of zero even though it is highly volatile, provided it is uncorrelated with the market. Tofallis (2008) provides a discussion of this,[8] together with a real example involving AT&T Inc. The graph showing monthly returns from AT&T is visibly more volatile than the index and yet the standard estimate of beta for this is less than one.

The relative volatility ratio described above is actually known as Total Beta (at least by appraisers who practice business valuation). Total beta is equal to the identity: beta/R or the standard

deviation of the stock/standard deviation of the market (note: the relative volatility). Total beta captures the security's risk as a stand-alone asset (because the correlation coefficient, R, has been removed from beta), rather than part of a well-diversified portfolio. Because appraisers frequently value closely held companies as stand-alone assets, total beta is gaining acceptance in the business valuation industry. Appraisers can now use total beta in the following equation: total cost of equity (TCOE) = risk-free rate + total betaequity risk premium. Once appraisers have a number of TCOE benchmarks, they can compare/contrast the risk factors present in these publicly traded benchmarks and the risks in their closely held company to better defend/support their valuations.

Interpretations of Beta Some interpretations of beta are explained in the following table:[9]

Value of Beta

## Interpretation Example An inverse

< 0 Asset generally moves in the opposite direction as compared to the index exchange-traded fund or a short position = 0 Movement of the asset is uncorrelated with the movement of the benchmark asset, whose growth is unrelated to the movement of the stock market

Fixed-yield

0<<1 Movement of the asset is generally in the same direction as, but less than the movement of the benchmark Stable, "staple" stock such as a company that makes soap. Moves in the same direction as the market at large, but less susceptible to day-to-day fluctuation. = 1 Movement of the asset is generally in the same direction as, and about the same amount as the movement of the benchmark A representative stock, or a stock that is a strong contributor to the index itself. > 1 Movement of the asset is generally in the same direction as, but more than the movement of the benchmark Stocks which are very strongly influenced by day-to-day market news, or by the general health of the economy. It measures the part of the asset's statistical variance that cannot be removed by the diversification provided by the portfolio of many risky assets, because of the correlation of its returns with the returns of the other assets that are in the portfolio. Beta can be estimated for individual companies using regression analysis against a stock market index. An alternative to standard beta is downside beta.

Extreme and interesting cases Beta has no upper or lower bound, and betas as large as 3 or 4 will occur with highly volatile stocks.

Beta can be zero. Some zero-beta assets are risk-free, such as treasury bonds and cash. However, simply because a beta is zero does not mean that it is risk-free. A beta can be zero simply because the correlation between that item's returns and the market's returns is zero. An example would be betting on horse racing. The correlation with the market will be zero, but it is certainly not a risk-free endeavor. A negative beta simply means that the stock is inversely correlated with the market. A negative beta might occur even when both the benchmark index and the stock under consideration have positive returns. It is possible that lower positive returns of the index coincide with higher positive returns of the stock, or vice versa. The slope of the regression line in such a case will be negative. Using beta as a measure of relative risk has its own limitations. Most analyses consider only the magnitude of beta. Beta is a statistical variable and should be considered with its statistical significance (R square value of the regression line). Higher R square value implies higher correlation and a stronger relationship between returns of the asset and benchmark index. If beta is a result of regression of one stock against the market where it is quoted, betas from different countries are not comparable. Staple stocks are thought to be less affected by cycles and usually have lower beta. Procter & Gamble, which makes soap, is a classic example. Other similar ones are Philip Morris (tobacco) and Johnson & Johnson (Health & Consumer Goods). Utility stocks are thought to be less cyclical and have lower beta as well, for similar reasons. 'Tech' stocks typically have higher beta. An example is the dot-com bubble. Although tech did very well in the late 1990s, it also fell sharply in the early 2000s, much worse than the decline of the overall market. Foreign stocks may provide some diversification. World benchmarks such as S&P Global 100 have slightly lower betas than comparable US-only benchmarks such as S&P 100. However, this effect is not as good as it used to be; the various markets are now fairly correlated, especially the US and Western Europe.[citation needed] Derivatives and other non-linear assets. Beta relies on a linear model. An out of the money option may have a distinctly non-linear payoff. The change in price of an option relative to the change in the price of the underlying asset (for example a stock) is not constant. For example, if one purchased a put option on the S&P 500, the beta would vary as the price of the underlying index (and indeed as volatility, time to expiration and other factors) changed. (see options pricing, and Black Scholes). Criticism Seth Klarman of the Baupost group wrote in Margin of Safety: "I find it preposterous that a single number reflecting past price fluctuations could be thought to completely describe the risk in a security. Beta views risk solely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments. The price level is also ignored, as if IBM selling at 50 dollars per share would not be a lower-risk investment than the same

IBM at 100 dollars per share. Beta fails to allow for the influence that investors themselves can exert on the riskiness of their holdings through such efforts as proxy contests, shareholder resolutions, communications with management, or the ultimate purchase of sufficient stock to gain corporate control and with it direct access to underlying value. Beta also assumes that the upside potential and downside risk of any investment are essentially equal, being simply a function of that investment's volatility compared with that of the market as a whole. This too is inconsistent with the world as we know it. The reality is that past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk."[10]

At the industry level, beta tends to underestimate downside beta two-thirds of the time (resulting in value overestimation) and overestimate upside beta one-third of the time resulting in value underestimation.[11](refactored from 3)

Another weakness of beta can be illustrated through an easy example by considering two hypothetical stocks, A and B. The returns on A, B and the market follow the probability distribution below:

## 7.5% 30% 30% 60% 7.5% 15%

The table shows that stock A goes down half as much as the market when the market goes down and up twice as much as the market when the market goes up. Stock B, on the other hand, goes down twice as much as the market when the market goes down and up half as much as the market when the market goes up. Most investors would label stock B as more risky. In fact, stock A has better return in every possible case. However, according to the capital asset pricing model, stock A and B would have the same beta, meaning that theoretically, investors would require the same rate of return for both stocks. This is an illustration of how using standard beta might mislead investors. The dual-beta model, in contrast, takes into account this issue and differentiates downside beta from upside beta, or downside risk from upside risk, and thus allows investors to make better informed investing decisions.[11](refactored from 5-6)