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The Capital Asset Pricing Model (CAPM) is a tool that can be used to identify whether a stock can potentially generate alpha based on its risk-return characteristics relative to the market index. For instance, suppose that we have a stock that returns 5 percent annually where the market index returns 7 percent. Given a high risk in terms of beta (discussed further below), the CAPM would argue that this stock is a non-alpha stock; since the return generated does not compensate an investor for the given risk. On the other hand, suppose that the stock now returns 10 percent while the market index returns 7 percent. Additionally, the stock has very low risk meaning that the risk of a lower return is, well, very low. This type of stock is said to generate alpha returns – it compensates an investor above and beyond that which they should be entitled given the risk and return on the market index. Parameters Average Daily Return vs. Expected Return: The average daily return shows the actual percentage daily return of each company over the given time period; this is the benchmark that we use against the expected return (the return that the CAPM says we should receive for holding the stock) to determine if a stock is undervalued or overvalued. The expected return is defined as the risk-free rate plus the product of the company’s beta and the average daily market return, i.e. Risk-free rate + ß(Average Daily Market Return) = Expected Return. If the stock lies above the Security Market Line, it is undervalued. If it lies below, it is overvalued. Beta: This figure tells us how volatile a company’s price is relative to its market index. In this case, a company with a beta of less than 1 is less volatile than the S&P 500 Index; a company with a beta of greater than 1 is more volatile than the S&P 500 Index. R-Squared: The R-Squared figure indicates the degree of the company’s returns that can be explained by the market return, e.g. a company with an R-Squared of 100% means that 100% of the company’s returns are “explained” by the market. Conversely, a company with an R-Squared of 0% means that none of the company’s returns can be explained by the market return. Jensen’s Alpha: Jensen’s alpha indicates the excess return generated by a stock over its expected return according to the CAPM. If a company has an average daily return greater than the expected return, then the excess return is defined as Jensen’s alpha. An Example of Dr Pepper Snapple Group ( DPS ) Companies Coca-Cola PepsiCo Dr Pepper Market Daily Return -0.04% -0.04% -0.04% Company Daily Return -0.04% -0.02% 0.06% Beta 0.64 0.75 0.74 R-Squared 45.39% 56.29% 39.66% Intercept -0.00018 0.00006 0.00082 Expected Return 0.02% 0.01% 0.01% Jensen’s Alpha -0.06% -0.03% 0.04% Valuation Non-Alpha Non-Alpha Alpha With data run over a one-year period (November 2014 to November 2015), we see that of the three companies, only Dr. Pepper shows alpha returns of 0.04%. This means that the average daily return of the company is 0.04% higher than what is required to compensate the investor for the risk of holding the stock. Moreover, we see that the company has the lowest R-Squared of the three companies, which means that only 39.66% of the company’s returns are attributable to the returns on the market index; the rest are unrelated to the market. Additionally, with a beta below 1, Dr. Pepper could be considered an ideal low-risk alpha stock on the basis of its past returns. Conclusion An obvious limitation of the Capital Asset Pricing Model is that it is backward looking and cannot predict the future. Nevertheless, it is extremely useful in the sense that it allows us to analyse other fundamental factors taking past returns into account. While past returns cannot predict future returns, understanding a stock’s return characteristics allows for a very handy guide in making investment decisions. Original source . Scalper1 News
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