Real-Life Math
Stock market analysts use all kinds of math all day, says analyst
Ming Lam.
Lam's job is to evaluate the potential success of a
stock based on its financial statements and its current performance on the
stock exchange.
Each analyst has their own style, or philosophy of
investing. This philosophy depends largely on their clients. For example,
if an analyst is working for a mutual fund company that specializes in retirement
investing for young adults, the analyst may be looking for higher-risk stocks.
If the client is older and closer to retirement, the analyst will look for
more secure investments.
There are hundreds of ratios and formulas
that a stock market analyst uses to estimate a stock's future performance
and risk.
"Many of the calculations involve university-level math and
an in-depth understanding of stock market terms and mechanisms," notes Lam.
Some calculations, however, are well within a high school student's ability.
A
couple of the formulas Ming uses are the Capital Asset Pricing Model (CAPM)
and the Price/Earnings Ratio. The CAPM is used to assess the price of a stock
in relation to general movements in the stock market. The Price/Earnings Ratio
is used to compare the price of the stock to other stocks in the same industry.
The
formula for CAPM is:
Stock price = A (stock's variance)
+ B (how the stock fluctuates in relation to the market) x M (market level)
Determining
the values of stock variance (A) and its fluctuation (B) involve university-level
math -- and often require hours of work and research to determine. Market
level is the composite index for the stock market in which the stock is traded.
The
formula for Price/Earnings Ratio (P/E) is:
P/E = stock
price / earnings per share
Stock price is the price of
the stock on the market. Earnings per share is the annual per share earnings
reported in the company's financial reports.
If the P/E for the
company is lower than that for the industry overall, an analyst would investigate
further to discover the reasons for its low price. Depending on those reasons,
an analyst might recommend investing in it.
The fund you advise has
a very conservative investment strategy. Since you cater to an older, less
risk-oriented client, you want only relatively secure, solid investments.
You've
been watching the stock of an established resource company -- ForSure. ForSure
produces paper, pulp products and packaging. It's a fairly volatile industry,
but you think it may have some potential for your fund. Currently, ForSure
stock is trading at $10.50. You want to assess the stock's price in relation
to the market.
The stock's variance is 3 and the stock fluctuates
at 0.01244. The exchange's composite index is 843.64. Is the price of the
stock overvalued? Undervalued?
A good analyst never relies on just
1 indicator. So you decide to check the P/E ratio of ForSure. According to
their quarterly report, net earnings per share is $0.69.
The P/E for
similar companies in the same industry on the exchange are as follows:
Trees
Unlimited = 0.76
Paper Pros = 0.67
Forests Forever =
0.38
The Pulp People = 1.17
Lumber Lovers = 1.10
Determine
the P/E for the industry. How does ForSure's P/E compare? Should you
recommend investing in it?