 Hello and welcome to this session. This is Professor Farhad in which we would look at what is the alpha of a stock? As always before we start, I would like to remind you to connect with me only then if you haven't done so Subscribe to my YouTube where I have one thousand eight hundred plus accounting auditing tax finance as well as Excel tutorials If you like my lectures, please like them and share them if they benefit you if you're listening to this recording It means you are here to looking for help. Please share this help with others Also visit my website farhadlectures.com for additional resources the complement and supplement this course as well as your other Accounting and finance courses. So what is the alpha of a stock? Well, simply put it's the difference between the expected return the stock expected return and its return Per the security market line or simply put following the cap M formula Which is the capital asset pricing model and what's that formula the expected return equal to the risk free rate Plus the beta times the expected return on the market minus the risk-free rate The best way to illustrate this is to work an example to show you how it works Suppose the return on the market is expected to be 14 percent We have a stock with the beta of 1.2 and the T-bill rate is 6 percent, which is the risk-free rate The SML would predict an expected return as follow will take the risk-free rate of 6 percent plus beta Times 16 a 14 minus 6, which is the risk premium will give us an expected return of 15.6 as per the security market line. So simply put When we say we said 14 percent here This is the expected return on the market and the expected return on the market Well, we should have a beta of 1 so this is right here and this is the security market line Any stock falls on this line. We say it's fairly priced Obviously, this this is a beta a stock a beta of 1 its expected return is 14 Now when we said a beta of 1.2 when we said this stock is a beta of 1.2 the expected return of this stock should be 15.6 So per the capital asset asset pricing model the expected return of this stock should be 15.6. Now, let's assume if one believes that the stock will provide instead a 17 percent return not 15.6. Well, if it if at beta 1.2, we're going to earn Let me change the color here if we're going to earn at beta 1.2 if we believe it's gonna be 17 percent It means we have a positive alpha of 1.4, which is the difference between 17 and 15.6. What should we do? It means this stock because it's not on the security market line It's above the security market line. It's above the security market line We should buy it if we expect it to be If we expect it to earn 17 percent because according to the cap M it should only earn 15.6 So this stock is outperforming outperforming. Let's assume the expected return is is only 15 So, let me do this in a different color if the expected return is let's say 15 is here. Let me go back Let's say let's use this color 15 will be right here. So 1.2 It will be someplace here 15 someplace here Then we have a negative beta of negative sex. What does that mean? It means this stock will underperform the market What should I do? I should sell the stock because it's underperforming and buy the stock that's overperforming Let's take a look at another example to see how this all fits together Stock XYZ has an expected return of 12 percent a beta of 1 Stock ABC is expected to earn 13 percent with a beta of 1.5 The market expected return is 11 percent risk free rate is 5 According to the cap M which stock is a better buy and what's the alpha for each stock actually from the alpha? We're gonna know which one is the better buy and plug the SML and the two stocks Well, we can't let them roughly first. Let's compute the cap the expected return for each stock starting with x y Z well, what we're gonna do. We're gonna take the risk free rate, which is 5 percent risk free rate plus the beta of x y c the beta of x y c is 1 plus 1 times The market return is expected to be What's the market return here it's expected to be 11 percent right here. Sorry 11 percent Minus the risk free rate 5 percent. This is all percentages. So let's do this 11 minus 5 equal to 6 6 times 1 equal to 6 So the expected return on XYZ stock is 11 percent Hold on a second the expected return is 11 percent per cap M. This is I'm gonna write this per Cap M, but we're saying the expected return is 12 We should definitely buy the stock because it's gonna outperform outperform By by how much what's the positive alpha positive alpha of 1? Well, let's look at ABC Maybe ABC has higher positive or maybe it lies exactly on the cap M line or maybe below the cap M line Let's see for ABC Again, the risk free rate is 5 percent. This is all percentage plus the beta for this stock is 1.5 Multiply by 11 percent minus 5 percent and that's 6 6 times 1.5 is 9 Plus 5 is 14. So per cap M Per cap M. We need to be earning. We should be earning 14 percent. Hold on a second. What we're saying is The expected return is 13. The difference between them is negative one. This is a negative alpha So this one has a positive alpha and This one a negative alpha, which one would you buy? You will buy the positive alpha because the positive alpha will out outperform the Market so what would it look like? It would look something like this. So this is 5 percent risk free rate. This is the beta. This is the expected return and Let's just draw a line here and start to plug in some numbers a beta of 1 Beta of 1 per cap M. It should be 11. So let's see. This is 11 So this is what it should be. But what happened is Beta of 1 the return was 12 Okay, this is for For that for the first stock the second stock the beta is 1.5 Per cap M per cap M. It should have been 14 percent. So this is going to be right here. So it should have been 14 percent, but what actually happened this stock is expected to earn only 13 so it has it has a negative beta. Sorry my you know Hopefully you get the point from the prior graph But hopefully also get the point the difference the difference of 1 percent positive alpha and 1 1 percent negative alpha Which stock would I buy? I will buy the stock with positive alpha because it's outperforming It's outperforming the cap M. As always, I'm gonna remind you to like this recording Please visit my website farheadlectures.com for additional resources for this course as well as your CPA preparation best of luck good luck study hard and most importantly Stay safe