Volatility is a key statistical concept with wide-ranging applications in finance. Investors can monitor the volatility of a stock, a stock index, or the earnings of a particular corporation. Earnings volatility is one of the key determinants of risk and of the resulting market price of a stock.
Volatility is a measure of how much the value of a variable fluctuates. If the temperature in a particular location varies greatly from one day to the next, for example, the temperature is said to exhibit high volatility. To measure volatility, statisticians calculate variance and standard deviation. While the formulas are somewhat complex, these calculations involve finding the average value of the variable over a period of time, and subtracting each individual value from the average to assess how much the individual observations deviate from the average. These variations are then fed into a formulation to quantify the volatility of the variable.
Earnings volatility refers to how stable, or unstable, the earnings of a corporation are. An analyst may work with annual or quarterly earnings figures. A company whose earnings fluctuate a great deal is a risky investment. Such volatile earnings make it very hard for management to plan ahead. Especially when funds must be borrowed for long-term investments, the predicted cash flow to honor debt obligations may not materialize. This can mean serious trouble, even resulting in seizure of assets by lenders, and, in extreme cases, bankruptcy. Therefore managers try not only to maximize earnings, but also to normalize them. Normalizing a variable means minimizing fluctuations and thereby reducing its volatility.
Stock Price Volatility
Another variable that analysts closely track is the volatility of the stock price. Since stocks trade and are priced on every business day, a lot more stock price data accumulates than earnings data. Hence, analysts do not need to wait for years before they can calculate the volatility of a stock's price. Generally, the more stable the earnings of a corporation, the more stable the price of its stock. Investors prefer stocks with stable prices and a steady uptrend. This makes financial planning easier and minimizes the risk of a sudden, catastrophic loss.
Not all earnings volatility is bad. Similarly, not all stability is good. If a company was making a very small, unsatisfactory amount of profit year after year, its earnings would be highly stable, but such a company would be an unattractive investment prospect. When a corporation is finally starting to turn things around and grow its profits, the earnings volatility will increase because there will be a dramatic and sudden change in earnings. Such volatility is positive. Therefore, as with every other financial measure, volatility must be evaluated within the right context.
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