Alpha isn’t a bro-lifestyle choice. It’s a measurement that new investors need to learn so they can have a headache over all the financial concepts they’re juggling in their repertoire.
The concept 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 explaining it, 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 that particular screener.
What does that percentage measure? Alpha measures if your stock screener has beaten the market’s return.
Why is that measurement valuable? Because 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
If you’re still juggling how that number came up, keep reading! 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 of the business.
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.
Expected Return: $100
Actual Return: $120
If Barney consistently makes over $100 daily, the lemonade stand will have a positive Alpha. But if he consistently makes under $100 daily, it would mean a negative Alpha.
Several factors can impact Alpha, so remember it is 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, but you could look at the Alpha along with CAPM.
CAPM (Capital Asset Pricing Model) is a foundational metric for the valuation of equity investments. The formula is below,
- E[ri]= Asset return
- Rf= Risk-free rate
- Bi= Beta for asset
- E(rm) = 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, which 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 consider. 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 terminologies, remember that finance has many factors, so 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!