Stock Price Volatility

The analysts pegged Google's one month at-the-money implied volatility at around 45 percent, the highest in their universe of large technology stocks.

Implied volatility is a statistical measure related to how much a stock is expected to move up or down on an annualized basis calculated by current option prices.

So why is Google's volatility so high? The answer is quite simple, but for those without a financial background I think its worth explaining. Remember that stocks can roughly be characterized as growth or value, depending on whether their price is mostly based on expectation of large future earnings or on a stream of earnings like the present ones. The way the numbers work, it turns out the small uncertainties in the growth rate of a growth company have a huge impact on the total amount of money it will return. This is analogous to the fact that earning slightly more in an index fund, or paying slightly less in taxes, has a big impact on long-term return.

Suppose that a value stock is currently paying 1$/share, and we expect it to grow at 3%, but it could actually grow at 2% or 4%. The former case leads to dividends of $1, $1.02, $1.04, $1.06, $1.08...and the latter to divdends of $1, $1.04, $1.08, $1.12, $1.17. Now consider a growth stock currently paying 0.10 cents/share. We expect it to grow at 30%, but it could grow at 20% or 40%. Now its dividends look like $0.10, $0.12, $0.14, $0.17, $0.21 or $0.10, $.14, $.20, $0.27, $0.38.

So you can see that this variance in the low growth rate of the value stock leads to a result in 5 years of $1.08 vs. $1.17, whereas the same variance in the growth stock leads to a result in 5 years of $0.21 vs $0.38. The relative difference is much larger. And Google is not just a growth stock, but an insane growth stock, with revenue doubling and profit quintupling over the last year. Small differences in just how fast it grows imply large differences in its expected dividend stream, which is the cornerstone of stock price.

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