Stock market investment: Alpha, Beta and stuff

Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers’ performances. Often, the return of a benchmark is subtracted in order to consider relative performance, which yields Jensen’s alpha.

The alpha coefficient (α_i) is a parameter in the capital asset pricing model (CAPM). It is the intercept of the Security Characteristic Line (SCL). Alternatively, it is also the coefficient of the constant in a market model regression.

It can be shown that in an efficient market, the expected value of the alpha coefficient is zero. Therefore the alpha coefficient indicates how an investment has performed after accounting for the risk it involved:

• α_i < 0: the investment has earned too little for its risk (or, was too risky for the return)
• α_i = 0: the investment has earned a return adequate for the risk taken
• α_i > 0: the investment has a return in excess of the reward for the assumed risk

For instance, although a return of 20% may appear good, the investment can still have a negative alpha if it’s involved in an excessively risky position.

Besides an investment manager simply making more money than a passive strategy, there is another issue: Although the strategy of investing in every stock appeared to perform better than 75 percent of investment managers, the price of the stock market as a whole fluctuates up and down, and could be on a downward decline for many years before returning to its previous price.

The passive strategy appeared to generate the market-beating return over periods of 10 years or more. This strategy may be risky for those who feel they might need to withdraw their money before a 10-year holding period, for example. Thus investment managers who employ a strategy which is less likely to lose money in a particular year are often chosen by those investors who feel that they might need to withdraw their money sooner.

The measure of the correlated volatility of an investment (or an investment manager’s track record) relative to the entire market is called beta. Note the “correlated” modifier: an investment can be twice as volatile as the total market, but if its correlation with the market is only 0.5, its beta to the market will be 1.

Investors can use both alpha and beta to judge a manager’s performance. If the manager has had a high alpha, but also a high beta, investors might not find that acceptable, because of the chance they might have to withdraw their money when the investment is doing poorly.

These concepts not only apply to investment managers, but to any kind of investment.

A coefficient measuring a stock’s relative volatility to a market index, such as the S&P 500 Index. A manager with a Beta greater than 1.0 is more volatile than the market, while a manager with a Beta less than 1.0 is less volatile than the market.

“An important measure of a stock’s (or a portfolio’s) volatility in relation to the Standard & Poor’s 500, which by definition has a beta of 1.0. A beta higher than this implies greater volatility than the overall market. Thus, a stock with a beta of 1.5 will move up 15 percent when the market rises 10 percent. In good times, high betas imply high returns, since a beta above 1.0 amplifies the market’s movements. In bad times, of course, a beta below 1.0 is desirable, since you wouldn’t want your portfolio to magnify downward movements. Ideally, you want a low beta and high returns, which is hard to get. You can lower the overall beta of your portfolio by adding lower beta stocks to the mix, in effect diversifying away some of the volatility.”

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How to value stocks: Earnings based valuations

Its very normal to value a company via its earnings, often referred to as net income or net profit. Essentially earnings are the money left after all the bills are paid.  To compare companies like-for-like investors measure earnings with an earnings per share (EPS) formula.

EPS

To find the EPS of a company you divide the amount of earnings of a company (in currency) by the number of shares the company has outstanding. We will use good old XZY PLC for our examples:

XYZ PLC produced $1 million earnings in the last 12 months and has 1 million shares outstanding; our EPS formula would produce an EPS of $1.

$1mil earnings /1mil shares = $1 EPS

P/E

Unfortunately the EPS tells us nothing about the companies shares fair value, we need something to compare relative to its share price. Many investors use another formula, the price/earnings ration. P/E looks at the share price and divides it by the last four quarters worth of earnings. XYZ PLC volunteers yet again; the current share price of XYZ PLC is at $10 a share:

$10 share price / $1 in EPS = 10 P/E

Sometimes called a multiple the P/E is often compared to the current rate of growth in the EPS, if both are approximately equal then fair value could be argued, this assumes that the P/E ratio at 10 is roughly inline with the companies current growth rate of lets say 11% for XYZ PLC, this would make P/E relative to current earnings growth a more sensible measurement, if on the other hand a companies growth decreases then P/E would not make sense as a measurement tool.

Both of these methods produce a “trailing” ratio, in other words the methods are based on historical data and benchmark what has happened. Quite a few investors I have meet stop here and use this data for their “informed” decision on a stock, frankly I feel this is a leap of faith and alike driving car while firmly fixed on the rear view mirror.

Since XYZ PLC has a current growth rate of 11% we can extend the use of P/E, I don’t want to look at the past for a decision, I want to forecast into the future. For this we can use two simple methods, these are the “P/E & Growth” (PEG) and the “year ahead P/E & Growth” (YPEG).

PEG

To use PEG we expand the growth rate out into the future and then compare it to its trailing P/E.

10 Trailing P/E / 11% projected EPS growth rate = 0.90 PEG

The lower PEG ratio the more of a bargain the companies’ price is. As you can see the 1% increase in current growth compared to its trailing valuation of 10% growth shows up in our analysis using PEG.

YPEG

YPEG uses the same assumption but uses different data. Instead of using trailing earnings data YPEG looks at the price to earning estimates for the coming year, then we apply 5 year growth rates estimates found at many quote sources.

So, if the forward P/E is 10 and we expect the company growth at 20% over 5 years, the YPEG is equal to 0.5.

We should not use PEG or YPEG in isolation, they make excellent measures if viewed with other methods, they do not provide one-stop-shop magic numbers.

JAL shares dumped