Earnings Per Share - EPS

What Does Earnings Per Share - EPS Mean?

The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability.

Calculated as:

When calculating, it is more accurate to use a weighted average number of shares outstanding over the reporting term, because the number of shares outstanding
can change over time. However, data sources sometimes simplify the calculation by using the number of shares outstanding at the end of the period.

Diluted EPS expands on basic EPS by including the shares of convertibles or warrants outstanding in the outstanding shares number.

Earnings Per Share - EPS

Earnings per share is generally considered to be the single most important variable in determining a share's price. It is also a major component used to calculate the
price-to-earnings valuation ratio.

For example, assume that a company has a net income of $25 million. If the company pays out $1 million in preferred dividends and has 10 million shares for half
of the year and 15 million shares for the other half, the EPS would be $1.92 (24/12.5). First, the $1 million is deducted from the net income to get $24 million,
then a weighted average is taken to find the number of shares outstanding (0.5 x 10M+ 0.5 x 15M = 12.5M).

An important aspect of EPS that's often ignored is the capital that is required to generate the earnings (net income) in the calculation. Two companies could
generate the same EPS number, but one could do so with less equity (investment) - that company would be more efficient at using its capital to generate income
and, all other things being equal, would be a "better" company. Investors also need to be aware of earnings manipulation that will affect the quality of the earnings
number. It is important not to rely on any one financial measure, but to use it in conjunction with statement analysis and other measures.

Beta
What Does Beta Mean?
A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model
(CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns..

Also known as "beta coefficient".

explain Beta
Beta is calculated using regression analysis, and you can think of beta as the tendency of a security's returns to respond to swings in the market. A beta of 1
indicates that the security's price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater
than 1 indicates that the security's price will be more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the
market.

Many utilities stocks have a beta of less than 1. Conversely, most high-tech Nasdaq-based stocks have a beta of greater than 1, offering the possibility of a higher
rate of return, but also posing more risk.

Variance
What Does Variance Mean?
A measure of the dispersion of a set of data points around their mean value. Variance is a mathematical expectation of the average squared deviations from the
mean.

explain Variance
Variance measures the variability (volatility) from an average. Volatility is a measure of risk, so this statistic can help determine the risk an investor might take on
when purchasing a specific security.

Risk
What Does Risk Mean?
The chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. Risk is
usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.

Many companies now allocate large amounts of money and time in developing risk management strategies to help manage risks associated with their business and
investment dealings. A key component of the risk mangement process is risk assessment, which involves the determination of the risks surrounding a business or
investment.

explain Risk
A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the
potential return. The reason for this is that investors need to be compensated for taking on additional risk.

For example, a U.S. Treasury bond is considered to be one of the safest investments and, when compared to a corporate bond, provides a lower rate of return. The
reason for this is that a corporation is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate bond is higher,
investors are offered a higher rate of return.

Systematic Risk
What Does Systematic Risk Mean?
The risk inherent to the entire market or entire market segment.

Also known as "un-diversifiable risk" or "market risk."

explain Systematic Risk

Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification.
Whereas this type of risk affects a broad range of securities, unsystematic risk affects a very specific group of securities or an individual security. Systematic risk
can be mitigated only by being hedged.

Even a portfolio of well-diversified assets cannot escape all risk

Unsystematic Risk
What Does Unsystematic Risk Mean?
Company or industry specific risk that is inherent in each investment. The amount of unsystematic risk can be reduced through appropriate diversification.

Also known as "specific risk", "diversifiable risk" or "residual risk".

explains Unsystematic Risk

For example, news that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to
be unsystematic risk.

Covariance
What Does Covariance Mean?
A measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns move together. A negative
covariance means returns move inversely.

One method of calculating covariance is by looking at return surprises (deviations from expected return) in each scenario. Another method is to multiply the
correlation between the two variables by the standard deviation of each variable.

explain Covariance
Possessing financial assets that provide returns and have a high covariance with each other will not provide very much diversification.

For example, if stock A's return is high whenever stock B's return is high and the same can be said for low returns, then these stocks are said to have a positive
covariance. If an investor wants a portfolio whose assets have diversified earnings, he or she should pick financial assets that have low covariance to each other.

Correlation
What Does Correlation Mean?
In the world of finance, a statistical measure of how two securities move in relation to each other. Correlations are used in advanced portfolio management.

explain Correlation
Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation co-efficient
of +1) implies that as one security moves, either up or down, the other security will move in lockstep, in the same direction. Alternatively, perfect negative
correlation means that if one security moves in either direction the security that is perfectly negatively correlated will move by an equal amount in the opposite
direction. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random.

In real life, perfectly correlated securities are rare, rather you will find securities with some degree of correlation.

Correlation (A, B) = _____Covariance (A, B)

Standard Deviation (A)* Standard Deviation (B)

Diversification
What Does Diversification Mean?
A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different
kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative
performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.

explain Diversification
Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk
reduction. Investing in more securities will still yield further diversification benefits, albeit at a drastically smaller rate.
Further diversification benefits can be gained by investing in foreign securities because they tend be less closely correlated with domestic investments. For
example, an economic downturn in the U.S. economy may not affect Japan's economy in the same way; therefore, having Japanese investments would allow an
investor to have a small cushion of protection against losses due to an American economic downturn.

Most non-institutional investors have a limited investment budget, and may find it difficult to create an adequately diversified portfolio. This fact alone can
explain why mutual funds have been increasing in popularity. Buying shares in a mutual fund can provide investors with an inexpensive source of diversification

Standard Deviation
What Does Standard Deviation Mean?
1. A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the
square root of variance.

2. In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment's volatility. Standard deviation is also known as
historical volatility and is used by investors as a gauge for the amount of expected volatility.

explain Standard Deviation

Standard deviation is a statistical measurement that sheds light on historical volatility. For example, a volatile stock will have a high standard deviation while
the deviation of a stable blue chip stock will be lower. A large dispersion tells us how much the return on the fund is deviating from the expected normal returns.

There are a number of ways to calculate the investment return of an account. We discussed some of these (real return, total return and risk-adjusted return) in the
Quantitative Methods section, and bond yields (yield-to-maturity, yield-to-call and the real interest rate) were discussed in the Fixed Income Secutities section.
You will not be tested on the actual formulas, so we have not included them here (other than those provided for clarity). In this section we'll focus on return
measures:

Return Measures

• Return on investment (ROI) - this is the classic measure of performance, taking into account all cash flows (including dividends, interest, return of
principal and capital gains). To calculate, simply divide the sum of all cash flows by the number of years the investment is held and then divide that
amount by the original amount invested.

• Risk premium - the risk premium is the higher return that is expected for taking on the greater risk associated with investing in a growth stock, versus a
stock from a more established company.

• Risk-free rate of return - the current rate for Treasury bills is typically used in calculations, such as risk-adjusted return and the Sharpe ratio.

• Expected return - since the expected return is the average of the probability of possible rates of return, it is by no means a guaranteed rate of return.
However, it can be used to forecast the future value of a portfolio and also provides a guide from which to measure actual returns.

o It is an integral component of the Capital Asset Pricing Model, which calculates the expected return based on the premium of the market rate over
the risk-free return, as well as the risk of the investment relative to the market as a whole (beta).

• Holding period return - this refers to the return for the period of time the investment was actually held. This can be more meaningful than an annualized
rate of return, particularly for investments held short term. However, the standard deviation of returns depends on the holding period, since stock returns
are more volatile over shorter periods of time. As a result:

o the shorter the holding period, the greater the variability of the return

o the longer the holding period, the smaller the variability of the return

• Excess returns - this is the amount of return over and above what is expected based on the beta of the stock or portfolio.

• Internal rate of return (IRR) - this is the interest rate that makes the net present value of a series of cash flows equal to zero. The internal rate of return
can only be calculated by trial and error (or with a financial calculator) unless the investment has only a single cash flow, such as a zero-coupon bond. In
that case the calculation is:

Internal rate of return = (Payoff/Investment) - 1

Portfolio Variance = w2A*σ2(RA) + w2B*σ2(RB) + 2*(wA)*(wB)*Cov(RA, RB)

Where: wA and wB are portfolio weights, σ2(RA) and σ2(RB) are variances and
Cov(RA, RB) is the covariance