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Use Alpha to Make Smarter Choices

The concept of Alpha is important because it allows for juxtaposing the stock you’re evaluating against other factors (like a benchmark) in the market. Keep reading to learn what Alpha is, an analogy, and why you need to be able to apply it in your investment journey.

What is Alpha?

Alpha is a percentage that appears in every stock screener you create with Equities Lab. When you create a screener, a table will pop up with the Alpha percentage for it.

What does that percentage measure? Alpha measures if your stock screener has beaten the market’s return.

Why is that measurement valuable? It allows you to visualize if a stock or strategy adds value and has the correct expected return rate. For example, using the S&P 500 as a benchmark, a strategy would have an annualized alpha of 3% if it, on average, beats the S&P 500 by 3%.

Alpha Taking Over a Lemonade Stand

Let’s go through an analogy to help make it more clear. Barney has his thriving lemonade stand, whose performance is supposedly improving because of the momentum hypothesis. He wants to ensure that the business is doing as well as it should, so he decides to calculate the Alpha.

Barney has an expected return rate of $100 dollars a day. If one particular day has a greater return, such as $120, that extra $20 is the Alpha. The formula below isn’t the technical formula for calculating Alpha, but gives us a simple definition of Alpha that may make it easier to understand.

Alpha = Actual Return – Expected Return

Expected Return: $100

Actual Return: $120

$120 – $100

Alpha = $20

If Barney consistently makes over $100 daily, the lemonade stand will have a positive Alpha. If it consistently makes under $100 daily, it would have a negative Alpha.

Several factors can impact Alpha. Remember it is only one of many metrics used to evaluate a stock.

Alpha and CAPM

You wouldn’t want to only look at the Alpha of a company. Looking at the Alpha along with CAPM is a good idea, though.

CAPM (Capital Asset Pricing Model) is a foundational metric for the valuation of equity investments. The formula is below,

E[r_i]=r_f+B_i(E(r_m)-r_f)

E[r_i]= Asset return
R_f= Risk-free rate
B_i= Beta for asset
E(r_m) = Market return

Both Alpha and CAPM evaluate the performance of a stock, but from different perspectives;

Alpha will show if a stock has reached, outperformed, or underperformed its expected return rate.
CAPM will show the expected return rates (through Beta) based on risk and market performance.

Alpha and Beta are used together to calculate and analyze returns. It is a standard way investors indicate the value of a stock.

Stay On Top of Terminology

Although you can’t rely solely on Alpha to predict a stock’s success, it is an important measurement to use. Just as you want to see accounts receivable and payable, the market cap, or even the P/E, the investigation of Alpha is just as crucial.

As you continue to juggle all these terms, remember that finance has many factors. Learning what you can and applying what you know is where success will turn up. Keep up with Equities Lab’s content to be able to tackle the market!