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Business and Finance

How Risk Is Measured Within Stock Investment

Value at Risk (VaR). It measures the probability of future portfolio losses remaining within a certain range. For instance, if a given portfolio has a one-day 2% VaR of $50,000, then the likelihood of the portfolio to decline in a given day by more than $50,000 is 2%. That implies that an investment will expect not more than once a portfolio decline that is greater than $50,000 every 50 days.

Alpha. It takes and compares the volatility of a fund portfolio or security and its risk-adjusted performance to a benchmark index. Alpha is now the extra return of the investment relative to the return of the benchmark index. An investor will know if the fund portfolio performs well if it gives a positive alpha. A negative alpha, on the other hand, indicates an underperformance of the fund portfolio.

Beta. It takes and compares the volatility of a fund portfolio to the whole market by using regression analysis. Since the market has a constant beta of 1, portfolio and security are measured by their individual level of deviation from the market. A deviation of more than 1 indicates a more volatile portfolio, whereas a deviation of less than indicates that the portfolio is less than the market.

R-Squared. It indicates the percentage of the movements of a security or a fund portfolio and is analyzed by movements in a benchmark index. For a fund to perform like the index, it must have a score of 70 per cent and above.

Standard Deviation. It indicates how much the return on a fund portfolio or security is deviating from the projected returns as per its previous performance. A high standard deviation indicates that a stock is a volatile stock, with a low standard deviation indicating a less volatile one.

Discounted Cash Flow Model

In an investment scenario, discounted cash flow (DCF) is an essential valuation method that is used to estimate how valuable a project will be. The method uses and analyses the future free cash flow estimates and discounts them by means of an annual rate to come up with their present values (PVs). The present value is then used to assess the value of the investment. When all the cashflows are added, they give the net present value (NPV). Usually, a higher value from the discounted cash flow than the current cost of the investment indicates that the investment is positive. Discounted Cash Flows are calculated using the formula below.

PV = CF1 / (1+k) + CF2 / (1+k)2 + … [TCF / (k – g)] / (1+k) n-1

Where:

PV = present value

CFi = Year i cash flow

TCF = cash flow of the terminal year

k = discount rate

g = growth rate postulation in perpetuity beyond a terminal year

n = the number of periods, including the terminal year, in the valuation model

Investors can use a variety of discount rates and cash flow analyses in a discounted cash flow model. An example of calculating free cash flows is as follows: adding operating profit, amortization of goodwill, and depreciation and then subtracting capital expenditures, change in working capital, and cash taxes. Even though these discounting cash flow calculations appear complex, the aim of the analysis is just to estimate the money that an investor would receive from a project and to make adjustments for the time value of his or her money. It is, however, difficult to come to a realistic estimate of the cash flows for a longer period, which is why the model uses a terminal value estimate beyond ten years. The major shortcoming of this model is that it is simply a mechanical valuation tool where a small change in the input results in huge changes in the company’s value. 

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