What is the Expected Value (EV)?
Expected value is a mathematical calculation that finds the anticipated value of an investment or a product on the basis of various possibilities that are taken into consideration, like the change in the value from time to time and the time period for which the price is being considered. The Expected Value can be calculated using the outcomes and the likelihood of these outcomes to occur. It facilitates an investor to zero-in on an investment that would reap the maximum benefits.
Expected Value Calculation
The formula for expected value is simple as it could be, the probability distribution is multiplied by the outcomes and all total is added to arrive at the expected value.
- Px = Probability distribution
- X = Outcomes
Expected Value Calculation Examples
Below are some examples of the expected value.
- The best example to understand the expected value is Dice. A dice has 6 sides and the probability of getting a number between 1 to 6 is 1/6.
- If we assume X as the outcome of a dice that is rolled, X is the number that appears on the top of the rolled dice.
- Since the probability of the numbers is not given we will go ahead with the probability of 1/6 in our calculations.
The calculation for EV will be as below:
The below table shows the number of days you’ll go to the gym and its probability.
- If you see add up the probability in the table above
- Since the probability is given in this case, we can directly calculate the expected value by multiplying the number of days with the probability.
To explain this, according to the above information, the expected number of days that you will head to the gym is roughly two days a week. As per the calculation, it is 1.95 so this means you can say that in 20 weeks you went to the gym 39 times (1.95 * 20).
There might be weeks where you wouldn’t have visited the gym and there might be weeks when you went on all seven days. This helps in understanding that even though the distribution of days attending the gym might not be constant but the rough estimate can be realized.
- Investors and managers can benefit in decision making to analyze whether investing in a stock or a project is worthy of generating returns.
- Can highlight red flags in case an investment is going to underperform.
- Various outcomes are combined to arrive at a single outcome which eases decision making.
- The easy calculation makes it accessible for anyone with basic mathematic skills to calculate the expected value.
- Considers every possibility of outcome to calculate the expected value.
- It is based on mathematical calculations and is a numerical representation of the future value of any investment or product; it is also based on probabilities and assumptions which might not actually depict the correct picture.
- The EV depends on probability which is highly subjective.
- This is an average of all possible outcomes and hence it does not give the actual result or outcome.
- It cannot be used for a one-time activity; it can only be used for scenarios where the outcome is repeated.
- It does not give a view of the risk involved and is a simple representation of the possible expected value.
- This may not actually correspond to any of the possible outcomes.
- In probability, the expected value is the weighted average of all possible outcomes with the weights given by the theoretical probabilities. It is represented by E(x).
- Since EV is derived by considering various trials it is not recommended for a one time or infrequent scenario.
- It can provide a fair idea of how the future value of an investment will be given the factors dependent on the calculation is pragmatic.
- EV is not foolproof yet the result obtained from the calculation can prove to be useful at the time of decision making.
- This is the future value of an investment or a product on the basis of various possibilities that are taken into consideration, like the change in the value from time to time and the time period for which the price is being considered.
- It is calculated mathematically by multiplying the outcomes with the probability distribution and adding all of them.
- In reality, the EV can differ from the calculated expected value since it based on assumptions but it can provide a pathway to understand roughly where the expected value will be.
- Investors can rely on expected value to decide on whether making an investment is worthy and can reap the maximum out of their investment.
This has been a guide to What is the Expected Value and its Definition. Here we discuss formula to calculate the expected value along with some examples, advantages, and disadvantages. You can learn more about excel modeling from the following articles –