The goal of an investor is to generate the highest return possible with the least amount of risk. One of the metrics investors use to determine a stock's risk-adjusted performance is "alpha," also known as "Jenson's alpha" or the "Jenson index." Alpha is the difference between a stock's actual return and its expected return adjusted for risk.
To calculate a stock's alpha value, you must first understand its beta value. A stock's beta value is its overall risk compared to other market investments. If beta is greater than 1.0, the risk is higher than the average market risk and its return should be higher than average market returns. Conversely, if beta is less than 1.0, the risk is lower than the average market risk and the return should be lower than average market returns.
Capital Asset Pricing Model
The capital asset pricing model is a formula used to determine an asset's expected return based on its beta value. When beta is less than 1.0, the stock's CAPM value will be lower than the average market return. When the beta value is greater than 1.0, the stock's CAPM value will be higher than the average market return.
When a stock's actual excess return differs from the return predicted by its CAPM value, the difference between the two values is alpha. To calculate a stock's alpha value, subtract its expected return as determined by the CAPM from its current return value. For example, if an asset's actual market return is 25 percent and the return predicted by the CAPM is 22 percent, its alpha is equal to 3 percent. Similarly, a stock with an estimated CAPM return of 30 percent and an actual return of 25 percent would have an alpha value of -5 percent.
A positive alpha value indicates that a given stock is performing better than expected, while a negative alpha value indicates that the stock is performing worse than expected. Investors typically view stocks with positive alpha values as good investments likely to produce excess returns. Conversely, investors expect a stock with a negative alpha value to perform poorly.
No investment is without risk. A stock's alpha value does not guarantee its future performance. A stock performing well at the time of the calculation may perform poorly in the future. Likewise, stocks currently producing negative alpha values may not always perform poorly.
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