Sharpe Ratio helps understand the excess return earned on the stock over and above the benchmark rate of return for a single unit of risk. This is calculated using 104 weekly price close points. Before understanding Sharpe ratio, it is important to know more about benchmark. Benchmark is the standard against which performance of a security is measured. If one were trying gauge the performance of a banking stock like Indusind Bank, it could be compared with Nifty Bank. Similarly auto stocks could be compared with Nifty Auto.

Let’s assume investor P buys 100 stocks of company XYZ on 1st Jan 2016 at Rs.40/share. On 1st Jan 2017 the price of the stock has risen to Rs.47. So 1 year return of the stock is (47 / 40) – 1 = 17.5%. Risk of holding the stock, calculated using volatility, during the year was 22%. During the same period benchmark indices moved up 7% and risk of the benchmark was 10%. Sharpe ratio is then calculated as (return on the stock – return on the benchmark index) / (standard deviation of the stock – standard deviation of the benchmark)

(17.5% – 7%) / (22% – 10%) = 1.05

So the investor earned 1.05% excess return over the benchmark return for every 1% of risk that he had to bear.

One can use sharpe ratio to compare the risk adjusted returns of different stocks. Other things remaining the same the stock with the higher sharpe ratio is obviously the better one.