An investor seeking to understand the dynamics of the stock market with maximising returns and minimising risks needs to know a bit of stock market math.
We will break down the complex financial and valuation models into simple concepts and statistics such as the following:
- Return on Investment
- Break-even analysis
- Risk assessment ratios
- Compounding
- Moving averages
- Leverage
- Return on investment (RoI)
To rev up its growth engine on a consistent basis, companies typically nèed to invest in various avenues. For such investments to deliver meaningful value, the company should generate a rate of return which is higher than the cost of capital required for funding such avenues.
The rate of return or theROI can be calculated using several methods such as IRR, NPV, payback and breakeven methods.
- Internal rate of return (IRR)
Every company while undertaking capital expenditure on projects decides on its 'hurdle rate' i.e. the minimum return on investment that the company seeks from the project. Then, IRR is calculated which is the rate at which the project breaks even and is calculated based on the project's cash flows. We then compare the IRR with the hurdle rate of the company. If the IRR is higher, it’s a worthwhile investment.
For example, project 'ABC' has an IRR of 22% and the company's hurdle rate is 15%, the project is likely to generate excess returns of 7% (22%-15%) over the hurdle rate.
- Net present value (NPV)
NPV is the discounted present value of an investment's future cash flows above the investment's initial cost.
Let us say the NPV of project 'APR' is ₹50 crore and the hurdle rate of the company is 15% means that the present value of the future cash flows of this investment using 15% corporate hurdle rate exceeds the initial investment by ₹50 crore.
- Break-even analysis
Break-even analysis allows you to understand units to be sold at a given price to cover one’s fixed costs i.e. to find out what is the Break-Even Volume (BEV).
Break Even point is the threshold at which revenue equals total expenses.
Break-even sales revenue
= fixed costs / (contribution margin / total sales)
- Estimate revenues by multiplying selling price by number of units sold.
- Calculate fixed cost per unit ie. all expenses that remain static irrespective of the volume produced, such as rent, electricity, administrative expenses etc.
- Calculate variable costs per unit, i.e. all expenses that change depending on the volume produced such as raw material cost.
- Calculate contribution margin by subtracting total variable costs from expected revenue.
Measuring risks
For an investor, the investment decision should always be in sync with his/her risk appetite. Hence, it is very critical to measure risk.
Some common measures of risk include :
- Standard deviation
- Sharpe ratio
- Beta value at risk (VaR)
- Treynor ratio
- Standard deviation
This conveys how volatile a fund is by measuring the deviation in the stock
returns as compared to its average returns spread over a period of time. If we were to take an example, a stock with deviation of 3% implies that it has a tendency to deviate by 3% from its average returns. Stocks having higher standard deviation are considered riskier than their counterparts having lower standard deviation. Hence. risk-averse investors prefer stocks having lower standard deviation.
- Sharpe ratio
This conveys whether a stock generates the returns in comparison with the total risk it carries. A higher Sharpe ratio indicates better returns from an investment in comparison to the total risk taken. Therefore, assessing the Sharpe ratio for similar stocks is useful for investors in identifying good stocks.
- Beta
It is a measure of the volatility of the stock in response to market fluctuations as compared to the index. A beta of 1 implies an equivalent shift in the prices compared to the index movement, a positive beta of more than 1 indicates a greater shift in the stock prices as compared to the index and a negative beta implies the opposite movement in the prices. Risk-averse investors should consider a stock with positive beta less than 1 as it conveys that the stock prices aren’t that severely impacted by volatility. Investors with a higher risk appetite can consider stocks with a beta of greater than 1.
- Treynor ratio
This measures the risk-adjusted returns delivered by a stock, similar to the Sharpe ratio but considers only stock-specific risk instead of total risk. Thus, again a higher Treynor ratio is considered better.
- Compounding
Simply put, compounding is where you earn interest on the principal amount as well as the accumulated interest amount over successive periods. Over time, this interest snowballs into a substantial amount.
Here’s the compound interest formula:
A = P (1 + [r / n]) ^ nt
A = the amount of money accumulated after n years, including interest
P = the principal amount (your initial deposit)
r = the annual rate of interest (as a decimal)
n = the number of times the interest is compounded per year
t = the number of years (time) the amount is deposited for
- Moving averages
A moving average is a technical analysis tool used by traders and investors which signals the buy and sell points of a stock.
Moving average is calculated by adding a stock's price over a certain period and dividing the sum by the total number of periods. These periods of time could range from days to months.
Moving averages also identify the various highs and lows of stock price trends and help in analysing expected trend’s direction.
Moving averages basically smoothen out the stock price trend over a predefined time frame and helps plot support and resistance levels of stock price.
There are three types of moving averages: simple, linear, and exponential.
An example of simple moving average:
Let us assume 'ABC' stock closed at 40, 41, 40, 39, and 40 over the last 5 days, the 5-day simple moving average would be 40 [(40 + 41 + 40 +39 + 40) / 5 ].
- Leveraging
To leverage means to use borrowed funds to boost your investment.
Basically, an investor is buying on margin i.e. using borrowed money and less of his/her own money to buy stocks from the margin account through a registered stock broker.
The broker charges you an interest fee and the securities bought cash in account serve as a collateral on borrowed money/loan.
While buying on margin increases the potential to make money, the possibility of making losses is also magnified in case your selected stock performs badly.
As an investor, you are liable pay margin debt plus interest.