Sharpe Ratio:
Sharpe ratio gives a single value to be used for the performance ranking of various funds or portfolios . It measurse the risk premium of the portfolio relative to the total amount of risk in the portfolio. This risk premium is the difference between the portfolio's average rate of return and the riskless rate of return.
| Formula | Rp- Irf |
| SDp |
where; Rp stands for return on portfolio;
Irf means Risk free rate of return which in
SDp: Standard deviation of portfolio.Which is the total risk.
The advantage of sharpe ratio is that it assigns highest values to assets that have best risk adjusted average rate of return. It is also known as reward to volatility ratio.
Example: A company is considering the ranking of two industries based in
| Industry | Expected Return | Standard Deviation |
| FMCG | 18% | 2 |
| Banking | 12% | 1.5 |
Risk free rate of return is 7%. and return on market portfolio is 16%.
Rank both these industries.
Putting the above mentioned formula we get
| FMCG: | Rp- Irf |
| SDp |
we get (18-7)/2=5.5%
Similarly we get 3.33% for banking.
So FMCG industry is better because the return on risk taken is higher in comparison to Banking.
The greater the portfolio’s sharpe ratio, the better is the risk adjusted performance. In Simple terms, Sharpe Ratio indicates the clear difference between the portfolios created by two different funds. For eg. If XYZ Fund has given 50% returns in 1 year & has a Sharpe Ratio of 1 & there is another fund ABC which has given 35% return over the same period with a Sharpe ratio of 2, then on the basis of Sharpe ratio, ABC fund is a better choice as it comes with a lesser risk but higher risk adjusted performance.
Expense ratio:
It measures expenses incurred by the investment company to operate mutual funds. The costs of owning a fund are called the expense ratio. This is distinct from the costs of buying a fund, which are the sales loads. The expense ratio represents the percentage of funds assets that go purely towards the expense of running the fund. The expense ratio covers the fees paid to fund manger, costs incurred in record keeping, custodial services, taxes, legal expenses, audit fees, accounting fees.It is also known as management expense ratio.Operating expense includes the fees paid to fund manager, costs incurred in record keeping; custodial services , taxes, legal expenses, audit fees.accounting fees
Alpha:
Alpha takes the volatility in price of a mutual fund and compares its risk adjusted performance to a benchmark index. The excess return of the fund relative to the returns of benchmark index is a fund’s ALPHA.
It is calculated as a return which is earned in excess of the return generated by CAPM.
Alpha is often considered to represent the value that a portfolio manager adds to or subtracts from a fund's return.
A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%.
If a CAPM analysis estimates that a portfolio should earn 35% return based on the risk of the portfolio but the portfolio actually earns 40%, the portfolio's alpha would be 5%. This 5% is the excess return over what was predicted in the CAPM model. This 5% is ALPHA.
Beta:
Beta measures the sensitivity of the stock to the market. For example if beta=1.5; it means the stock price will change by 1.5% for every 1% change in sensex.
It is also used to measure the systematic risk. Systematic risk means risks which are external to the organisation like competition, government policies. They are non-diversifiable risks. Beta of the market is always 1. The best index fund will have beta value equal to the market namely 1.
If beta>1 then aggressive stocks
If beta<1 then defensive stocks
If beta=1 then neutral
Price to Earnings ratio:
Popularly known as P\E Ratio.
It shows how much an investor is willing to pay for every Rupee earned by the company. A P\E ratio of a stock is 14, it means an investor is willing to pay Rs.14/- for every
Re 1/- earnings by the company. It also tells lot about the future growth/ earnings of the stock.
| Formula:= | Market price per share =P\E ratio. |
| Earnings Per share |
Eg: Consider the share price of reliance(RIL) to be Rs.500/-;Earnings of the company be RS.500000/- and number of outstanding shares be 5000
| Where EPS= | Rs500000= Rs100/- |
| 5000 |
| Then P\E= | 500 = 5. |
| 100 |
Conclusion: an investor is willing to pay Rs 5/- for every rupee company would be earning in future.
Important point: If the P\E of two stocks A & B is:
A 20
B 10
It does not mean that stock A is overvalued and stock B is undervalued. It just means that the investors have more confidence in the growth story of stock A rather than stock B.
However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company to a consumer goods company as each industry has much different growth prospects.
The biggest drawback in case of P\E valuation is that the Earnings in the denominator is an accounting concept which is prone to manipulation by the company.
Price-to-Book Ratio:
A ratio used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value per share.
It measures how aggressively the market values the firm.
A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company.
Price –To-Sales Ratio:
It is a ratio which is used to value start-up firms, since they do not have profit to show so sales is considered. Price to sales is calculated by dividing a stock's current price by its revenue per share for the trailing 12 months
A low P/S ratio is better since the investor would be paying less for each unit of sales
Price Earnings to Growth ratio:
Commonly known as PEG ratio.
It measures the value of the firm while taking into account the earnings growth.
PEG Ratio = Price earnings ratio
Annual EPS Growth
Investors prefer to use PEG ratio to value the firm instead of P/E ratio because PEG takes into consideration the factor called growth.
A lower PEG means that the stock is undervalued.
Keep in mind that the numbers used are projected and, therefore, can be less accurate. Also, there are many variations using earnings from different time periods (i.e. one year vs five year). Be sure to know the exact method your source is using.
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