Most Popular Equations for Stock Market Investors
Picking the best stocks weighs many factors and one of the best ways to narrow down the best stocks to buy is through the use of investment equations that stock market investors can use to identify the stocks with the probability of growing and the price going up over time.
Here are a few popular investment equations you need to know to become a great investor.
Basic Financial Ratios
In stock market investing, financial ratios help us make informed decisions. These metrics give us a snapshot of a company’s financial health and help us compare investment opportunities objectively.
Price to Earnings (P/E) Ratio
The P/E Ratio is our go-to metric for evaluating whether a stock is over or undervalued relative to its earnings. We calculate it by dividing the current market price of a stock by its earnings per share (EPS).
A lower P/E ratio may indicate that the stock is undervalued, while a higher P/E suggests it might be overvalued. For example:
| Company | Stock Price | Earnings Per Share (EPS) | P/E Ratio |
|---|---|---|---|
| XYZ Inc. | $50 | $5 | 10 |
This tells us that XYZ Inc. is trading at ten times its earnings.
Price to Book (P/B) Ratio
Our next important ratio, the P/B Ratio, contrasts a company’s market value to its book value. We find this ratio by dividing the stock price by the book value per share.
When a stock trades below its book value, it can be an indication that it’s undervalued. Here’s a quick view:
| Company | Stock Price | Book Value Per Share | P/B Ratio |
|---|---|---|---|
| XYZ Inc. | $50 | $25 | 2 |
A P/B Ratio of 2 suggests that the market values the company at twice its book value.
Debt to Equity Ratio
Lastly, the Debt to Equity Ratio is crucial for understanding a company’s financial leverage. We calculate this by dividing total liabilities by shareholders’ equity.
Ideally, we prefer companies with a lower ratio, indicating less reliance on debt to finance its operations:
| Company | Total Liabilities | Shareholder’s Equity | Debt to Equity Ratio |
|---|---|---|---|
| XYZ Inc. | $10,000 | $20,000 | 0.5 |
This ratio of 0.5 means XYZ Inc. has twice as much equity as it does debt, which is a healthy sign for us as investors.
Technical Analysis Indicators
As we navigate the stock market, it’s crucial to employ the right tools to assess potential investments. Technical Analysis Indicators provide us with mathematical calculations based on historical price, volume, or open interest information that aids in forecasting financial market directions.
Let’s explore some of the most utilized indicators to strengthen our investing strategy.
Moving Averages
Moving averages smooth out price data to identify the trend direction over a set period of time.
The Simple Moving Average (SMA) is the average stock price over a specific number of days. Meanwhile, the Exponential Moving Average (EMA) gives more weight to recent prices and responds more quickly to price changes than the SMA.
- SMA: Avg(Closing Prices over N periods)
- EMA: (Closing Price – EMA(previous day)) x Multiplier + EMA(previous day)
| Period | SMA | EMA |
|---|---|---|
| 10-day | $105 | $107 |
| 50-day | $102 | $103 |
| 200-day | $95 | $97 |
Relative Strength Index (RSI)
The Relative Strength Index (RSI) measures the speed and change of price movements, often signaling overbought or oversold conditions.
An RSI above 70 typically indicates a stock may be overbought, while an RSI below 30 could suggest it is oversold. We use this to gauge the momentum and timely entry or exit points.
- Overbought: RSI > 70
- Oversold: RSI < 30
Moving Average Convergence Divergence (MACD)
Lastly, the Moving Average Convergence Divergence (MACD) shows the relationship between two moving averages of a stock’s price.
We look at the MACD line and the signal line; when they cross, it suggests potential buy or sell signals. Significant trends can be discerned when the MACD crosses above or below the signal line.
- MACD Line: EMA(12 periods) – EMA(26 periods)
- Signal Line: EMA(9 periods of MACD Line)
- Histogram: MACD Line – Signal Line
| Indicator | Buy Signal | Sell Signal |
|---|---|---|
| MACD | MACD crosses above Signal Line | MACD crosses below Signal Line |
| RSI | RSI crosses above 30 | RSI crosses below 70 |
Fundamental Analysis Equations
When we look at investing, it’s crucial to understand the firm’s financial health. Two key tools at our disposal are Earnings Per Share (EPS) and Return on Equity (ROE).
Earnings Per Share (EPS)
Earnings Per Share (EPS) is a direct measure of a company’s profitability. It’s calculated by dividing the company’s net income by the number of its outstanding shares.
An increasing EPS over time signals that a company is growing its ability to generate profits.
The formula for calculating Earnings Per Share (EPS) is:
EPS = (Net Income – Preferred Dividends) / Average Outstanding Shares
Where:
- Net Income is the company’s total profits after taxes
- Preferred Dividends are any dividends paid to preferred stockholders
- Average Outstanding Shares is the average number of shares outstanding during the period
Using a table, we can effectively analyze and compare the EPS of different companies:
| Company | Net Income ($M) | Dividends on Preferred Stock ($M) | Average Outstanding Shares (M) | EPS ($) |
|---|---|---|---|---|
| A | 1,000 | 20 | 50 | 19.60 |
| B | 2,000 | 0 | 120 | 16.67 |
| C | 500 | 10 | 25 | 19.60 |
Return on Equity (ROE)
ROE measures a company’s ability to generate income relative to shareholder equity. It’s a gauge of the efficiency with which our invested capital is being used.
To calculate it, we divide the net income by the shareholders’ equity.
The formula for Return on Equity (ROE) is:
ROE = Net Income / Shareholders’ Equity
Where:
- Net Income is the company’s net profit
- Shareholders’ Equity is the company’s total equity, which is the difference between its total assets and total liabilities
Let’s take a look at how ROE is represented in a table for an easy comparison:
| Company | Net Income ($M) | Shareholder’s Equity ($M) | ROE (%) |
|---|---|---|---|
| A | 1,000 | 5,000 | 20 |
| B | 2,000 | 15,000 | 13.33 |
| C | 500 | 2,000 | 25 |
A higher ROE indicates that the company is using its investors’ funds more effectively to grow profits.
However, it’s important to note that these figures should not be viewed in isolation, as industry standards also play a critical role in evaluating their significance.
Value Investing Formulas
When we explore value investing, there are specific formulas we rely on to assess the intrinsic value of stocks. Our goal is to determine if a stock is undervalued compared to its current market price.
Discounted Cash Flow (DCF)
The Discounted Cash Flow (DCF) analysis is pivotal. It helps us understand the value of an investment based on its expected future cash flows, which are adjusted to their present value.
Here’s a simple outline of the process:
- Forecasting the expected cash flows
- Choosing an appropriate discount rate
- Calculating the present value of cash flows using the discount rate
The formula for calculating the Discounted Cash Flow (DCF) is:
DCF = CF1 / (1 + r)^1 + CF2 / (1 + r)^2 + … + CFn / (1 + r)^n
Where:
- CF1, CF2, …, CFn are the cash flows for each period
- r is the discount rate
- n is the number of periods
This formula is used to estimate the present value of future cash flows generated by an investment or a business.
Dividend Discount Model (DDM)
Another area we specialize in is using the Dividend Discount Model (DDM). This model is effective for companies that pay regular dividends.
The DDM calculates the present value of expected dividends, under the assumption that dividends will continue to grow at a steady rate.
The formula for the Dividend Discount Model (DDM) is:
Stock Price = D1 / (r – g)
Where:
- D1 is the expected dividend to be received at the end of the first year
- r is the required rate of return on the stock
- g is the expected dividend growth rate
Growth Investing Metrics
When we look at growth investing, certain metrics are pivotal for evaluating the potential of companies that are expected to grow at an above-average rate compared to other companies.
One key metric we focus on is the Price to Earnings Growth (PEG) Ratio.
Price to Earnings Growth (PEG) Ratio
The PEG Ratio measures a stock’s valuation. It also accounts for its expected earnings growth. This can often provide more context than the P/E ratio alone. Here’s how we calculate it:
| Component | Description | Calculation |
|---|---|---|
| P/E Ratio | Stock price to earnings per share | Price / Earnings |
| Earnings Growth | Annual projected earnings growth | Percentage Growth Rate |
To get the PEG Ratio, we divide the P/E Ratio by the Earnings Growth rate:
PEG Ratio = (P/E Ratio) / (Annual Earnings Growth Rate)
A PEG Ratio below 1 may suggest a stock is undervalued given its growth prospects. Meanwhile, a higher PEG Ratio could indicate a stock might be overvalued. However, context matters. We must consider the industry average and other factors to make informed decisions.
Portfolio Diversification Equations
When opting for investment in the stock market, it’s crucial to understand how to mitigate risk while aiming for optimal returns.
Two foundational concepts guide our strategic approach: the Modern Portfolio Theory and the Capital Asset Pricing Model.
Modern Portfolio Theory (MPT)
Developed by Harry Markowitz in the 1950s, the Modern Portfolio Theory is pivotal for assessing how well-diversified our portfolios are. Its core premise is that assets should not be evaluated in isolation but rather by how they interact with the rest of the portfolio.
We use the MPT to mathematically articulate the trade-off between risk and return. This helps us strive for a portfolio that offers maximum expected return for a given level of risk through proper asset allocation.
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model helps us understand the relationship between expected return and market risk. It illustrates the compensation investors require for taking on additional risk.
By using CAPM, we can calculate the expected return on an asset based on its particular sensitivity to market movements, known as beta ((\beta)). This insight is invaluable for building a diversified portfolio that aligns with your risk tolerance.
Learn More: Read about CAPM
Risk and Return Table:
| Asset | Expected Return | Risk-Free Rate | Beta | Market Premium | Expected Return (CAPM) |
|---|---|---|---|---|---|
| Asset 1 | 8% | 2% | 1.2 | 5% | 8.0% |
| Asset 2 | 12% | 2% | 1.5 | 5% | 11.5% |
| Asset 3 | 10% | 2% | 0.8 | 5% | 7.4% |
Risk Management Tools
In our investment activities, we give top priority to managing risk effectively. Let’s explore some essential tools that we use to quantify and control the level of risk associated with our stock market investments.
Sharpe Ratio
The Sharpe Ratio is our go-to measure for assessing risk-adjusted return. We calculate it by subtracting the risk-free rate of return from the expected portfolio return.
Then, we divide the result by the standard deviation of the portfolio’s excess return. This ratio shows us how much additional return we’re receiving for the extra volatility that we take on when we choose riskier investments.
Example of Sharpe Ratio Calculation:
| Expected Portfolio Return | Risk-Free Rate | Portfolio Standard Deviation | Sharpe Ratio |
|---|---|---|---|
| 8% | 2% | 10% | (8%-2%)/10% = 0.6 |
Beta Coefficient
The Beta Coefficient, often just called ‘beta’, measures a stock’s volatility relative to the overall market. It helps us understand a stock’s reaction to market movements.
If a stock has a beta greater than 1, it’s typically more volatile than the market. Meanwhile, a beta less than 1 indicates less volatility.
We use beta to help us build a balanced portfolio that aligns with our desired level of risk exposure.
Example of Stock Beta Values:
| Stock | Beta Value | Implication |
|---|---|---|
| Stock A | 0.8 | Less volatile, moves 80% for every 100% move in the market |
| Stock B | 1.2 | More volatile, moves 120% for every 100% move in the market |
By using tools like the Sharpe Ratio and Beta Coefficient, we can make informed decisions that align with our risk preferences and investment goals.
Related Reading
Read our article covering the most important math formulas for stock market investing.