Stock Research Pro

Measure the Trade-Off Between Risk and Return with the CAPM

Stock Research Pro — Tue, 09 Feb 2010 01:48:25 +0000

The Capital Asset Pricing Model (CAPM) is used to determine the appropriate rate of return of an asset. In calculating this expected return, the CAPM accounts for both risk and the time value of money and can be used to assign a discount rate for the purpose of asset valuation. The idea behind the CAPM model is that since even well-diversified portfolios take on some level of risk, rational investors should expect to be compensated for that risk.

The formula for the CAPM can be written as:

Expected Return = (Risk Free Rate + Risk Premium)

Using the calculator below, the time value of money is represented by the available risk-free rate of return to provide compensation to the investor for putting money into an investment for some period of time. The additional risk portion is represented by beta to compare the returns of the asset to overall market returns.

Generally speaking, the CAPM model says that if the expected return of the investment does not meet the investor’s required return, then the investment is not worthwhile.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

How Do You Calculate the Value of a Bond?

Stock Research Pro — Mon, 08 Feb 2010 00:53:53 +0000

A bond is essentially an ‘IOU’ set up between an investor and a company or government entity. Under the agreement, an interest rate is set and the timing of payments that the lender will receive during the life of the bond is defined. At the end of the bond’s life- its maturity- the principal amount is returned to the lender. Companies that are looking to expand often issue bonds in order to fund that expansion. Government entities also issue bonds to raise money or fund specific projects. Investing in bonds is different from investing in other types of debt securities in that the value of the bond can fluctuate over its lifetime as interest rates rise and fall. Because bonds can be bought and sold on a secondary market, bond investors should take the time to become familiar with the bond valuation process.

A basic bond valuation calculator is below.

Bond prices are influenced by market interest rates. For example, a bond purchased with a coupon rate of 10% becomes more valuable if market interest rates fall to 9%. When assigning a present value to a bond, an investor would discount the bond’s expected cash flows with the discount rate used being driven by currently available interest rates for debt instruments that offer comparable risks and maturities.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

What is the PEG Ratio and How is it Calculated?

Stock Research Pro — Sun, 07 Feb 2010 13:50:43 +0000

The PEG or “Price/Earnings to Growth” ratio is a measure used to value a stock based on the trade-off between the P/E ratio of the stock and the company’s forecasted growth. Made popular by Peter Lynch in his book “One Up on Wall Street”, the PEG ratio is closely tracked by many investors to help determine whether a stock is currently over or under priced when factoring for growth expectations of the company.

The formula for the PEG ratio can be written as:

PEG Ratio = (Price/Earnings) / Annual Earnings per Share Growth

A PEG ratio equal to one is thought to represent a fairly valued stock. For example, a company with a P/E ratio of 20 with a growth rate of 20% would have a PEG of 1. Like the P/E ratio, stocks with lower PEG ratios are seen as offering better value and a PEG ratio of less than 1 can indicate that the stock is currently undervalued. Value investors in particular may look for this attribute when choosing stocks for investment.

The PEG ratio is typically most beneficial when considering small and mid-cap growth companies as these organizations are more likely to pour their earnings back into the company to stimulate continued growth. Large-cap companies often allocate these earnings to dividend payments.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

How and Why to Calculate Your Personal Net Worth (Includes Calculator)

Stock Research Pro — Fri, 05 Feb 2010 12:48:48 +0000

Any good financial planner will tell you that the first step toward developing a long-term financial plan is calculating your personal net worth. Net worth is a better measure than your annual income or your credit score as it provides a snapshot of your current financial state; it is the difference between the assets you own and the liabilities you owe. That difference is represented by a single number that you can use to track your financial progress over time.

Calculating your net worth is like creating your own balance sheet using the equation:

Net Worth = Assets – Liabilities

Your assets are everything you own, including your house, cash savings, stocks and other business equity, bonds, insurance policies, your car, jewelry, collectibles, consumer durables, and the market value of other items. Your liabilities are everything you owe, including your mortgage, student loans, credit card debt and any debts you owe to others.

A negative net worth represents bankruptcy (at least on paper). A positive net worth means you’re doing something right. In either case, knowing your current net worth gives you a benchmark to mark your improvement.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

What is a Keogh Plan and Who is Eligible?

Stock Research Pro — Thu, 04 Feb 2010 11:59:39 +0000

A Keogh plan, also known as an “HR10 plan” is a tax-deferred retirement savings plan available to unincorporated businesses and self-employed individuals. While most Keogh plans are set up as defined contribution plans (meaning the company sets aside a defined percentage of money to benefit the employee), they can also be set up as defined benefit plans (the employee benefit is determined based on a formula that incorporates duration of time employed and the salary history). Keogh plan contributions are deducted from gross income, making reduced pre-tax income one of the key benefits of the plan. Additionally, contributions and earnings grow on a tax-deferred basis until the time of withdrawal.

Keogh plan participants may contribute up to 100 percent of their income to a yearly maximum of $49,000 in 2009 (increased from $46,000 in 2008). Like other retirement savings plans, Keogh plan investors can choose almost any type of investment instrument (except precious metals or collectibles) and the plan carries early withdrawal fees for any withdrawals made before the participant turns 59 years old and is retired.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

Calculate the Treynor Ratio to Measure Risk-Adjusted Portfolio Performance

Stock Research Pro — Thu, 04 Feb 2010 02:46:51 +0000

The Treynor Ratio or “Treynor Index” is used to measure investment returns against the available risk-free rate of return. Developed by Jack Treynor, the ratio provides an analysis similar to the Jensen and Sharpe ratios to enable investors to more clearly evaluate the trade-off between investment risk and return.

The formula for the Treynor Ratio can be written as:

Treynor Ratio = (Average Portfolio Return – Risk-Free Rate of Return) / Beta of the Portfolio

The element of risk incorporated into the ratio is known as “systematic risk”; that is, the risk associated with overall market or market segment fluctuations. Changes in interest rates, the business cycle, and the political climate provide sources of systematic risk as these risks cannot be eliminated through diversification and can impact the overall market. Because unsystematic risk (the risk associated with a specific company or industry) is not accounted for in the Treynor Ratio, the results are thought by many to be misleading.

Generally speaking, a higher Treynor Ratio indicates greater profitability when accounting for risk.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

Calculate Your Back-End Ratio for Mortgage Approval

Stock Research Pro — Tue, 02 Feb 2010 18:26:30 +0000

A back-end ratio is a measure used by mortgage lenders to determine the portion of the borrower’s monthly income that goes toward paying off debts. Also known as the “debt to income ratio”, the measure includes such things as credit card and other loan payments, child support, and mortgage payments.

The calculation for the back-end ratio can be written as:

Back-end Ratio = Total Monthly Debt / Gross Monthly Income

Generally speaking, lenders prefer to see a back-end ratio of less than 36%. But some lenders will make exceptions and approve loans to borrowers with back-end ratios of up to 50% if the borrower shows a very good credit history. In these scenarios, though, the borrower should be cautious as carrying a debt load this high can lead to financial problems.

While some lenders evaluate a borrower’s back-end ratio only, other lenders look at it in conjunction with the front-end ratio.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

Calculate Your Front-End Ratio for Mortgage Approval

Stock Research Pro — Tue, 02 Feb 2010 14:48:20 +0000

A front-end ratio is a measure used by mortgage lenders to determine how much a borrower can afford for a monthly mortgage. Specifically, the ratio calculates how much of the borrower’s income is used to make those monthly mortgage payments. The front-end ratio is calculated by dividing monthly household expenses by gross income with the result expressed as a percentage.

The formula for the front-end ratio can be written as:

Front-end Ratio = Monthly Housing Expenses / Monthly Income

Monthly income would be the annual gross income divided by 12. Monthly housing expenses would include the mortgage principal plus interest, taxes, and insurance (known as PITI). To be a satisfactory measure, lenders typically look for a front-end ratio that does not exceed 28% of the borrower’s monthly gross income.

As part of the mortgage approval process, lenders look at both the borrower’s front-end and back-end ratios.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

A Sector Rotation Strategy with Exchange-Traded Funds (ETFs)

Stock Research Pro — Tue, 02 Feb 2010 01:47:17 +0000

A sector rotation strategy is one that is undertaken by investors by actively managing their portfolios through asset allocation based on the status of the economic cycle and the businesses that tend to perform best at that specific point in the cycle. The term “sector” is used to describe a group of stocks that operate in a similar line of business and are affected by changes in the economy in similar ways and a sector rotation strategy calls for the active participation of the investor to periodically review portfolio holdings and make adjustments as the economic cycle progresses. While a sector rotation strategy is more time-consuming than a more passive strategy (like indexing) it has the potential to outperform those approaches.

Sector and industry exchange-traded funds (ETFs) provide one easy way for investors to implement a sector rotation strategy. Sector ETFs are built with stocks (or other instruments) from a single market to provide investors with “concentrated diversification” while reducing the risk associated with picking individual stocks. Sector ETFs are offered for a number of different industries, including healthcare, technology, and utilities.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

The Risk of Selling Naked (Uncovered) Put Options

Stock Research Pro — Mon, 01 Feb 2010 01:18:54 +0000

A naked put, also known as an “uncovered put” refers to the selling of a put option without having a short position in the stock for which the put was written. A put option gives the owner of that option the right (but not the obligation) to sell a predetermined amount of the underlying security at a set price and within a specified period of time. By having an accompanying short position in that stock, the seller of the put “covers” that contract.

A naked put is typically sold for purely speculative reasons as the seller of the put believes the stock price will stay above the strike price the expiration of the contract. While a naked put offers only a limited gain to the seller, it is a strategy with unlimited risk. If the stock price falls below the strike price before expiration, there is virtually no limit to the loss the seller can incur.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.