K-Ratio: Definition, Overview & Formula

KEY TAKEAWAYS

• K-ratios, which are determined using the value-added monthly index (VAMI), gauge an equity’s consistency of returns over time.
• The computation includes performing a linear regression on a Value-Added Monthly Index (VAMI) curve’s logarithmic cumulative return.
• When calculating risk, the K-ratio considers both the sequence of returns and the returns themselves.
• The ratio, which takes the return trend into account, calculates the security’s return over time and is a useful tool for evaluating the performance of stocks.

What Is the K-Ratio?

The K-ratio is a valuation indicator that looks at an equity’s return stability and the growth of return over time. A value-added monthly index (VAMI), which employs linear regression to follow the development of a $1,000 initial investment in the securities under consideration, provided the information for the ratio.

In 1996, Lars Kestner developed the K-Ratio to assess a strategy’s general profitability.

What Is the Formula for Calculating the K-Ratio?

The formula that is used to calculate the K-ratio is as follows:

What Does the K-Ratio Determine?

When calculating risk, the K-ratio considers both the returns and their chronological order. The computation includes performing a linear regression on a Value-Added Monthly Index (VAMI) curve’s logarithmic cumulative return.

 The K-ratio formula is then applied to the regression findings. The standard error of the slope reflects the risk, whereas the slope is the return, which should be positive.

How Is the K-Ratio Calculated?

The K-Ratio can be calculated with the help of the formula mentioned above. 

The returns are known to be taken into account by the K-ratio. In addition, it is known that the supplied parameter takes into account the relative order of returns when calculating risks. It is known that the computation entails applying linear regression to the VAMI or Value-added Monthly Index curve’s logarithm-based cumulative return. 

The K-ratio formula takes the results of regression into account. The projected positive return turns out to be the slope. The overall risk is understood to be represented by the standard error of the slope.

Where Is the K-Ratio Used?

The K-ratio was created so that a financial manager or investor might examine a set of data and attempt to draw a straight line with a minimum slant. It is used to assess an equity’s long-term return performance in relation to its risk.

Example of K-Ratio

Because it considers the return trend rather than just point-in-time snapshots, the ratio is seen to be a helpful instrument for evaluating the performance of individual stock returns. It quantifies the return of the security over time.

The K-ratio makes it possible to compare the cumulative returns of several stocks (and equity managers) across time. By considering the sequence of returns, it differs from the popular Sharpe measure. In reality, the K-ratio is intended to be compared against and used in conjunction with other performance indicators.

Summary

A statistical tool called the K-Ratio allows us to quantify two concepts: the growth of return and the consistency of that growth over a given time period. It is frequently employed to assess the consistency of the return on that risk as well as the risk vs. reward of investing in a specific asset.

The rise of return and the consistency of that growth over a given period are two aspects that the K-Ratio helps us gauge. Better performance can be predicted by a greater K-Ratio than by a lower K-Ratio.