Harmonic Mean

Assignment:
Define and provide formula, plus examples for each of the following:
1. Harmonic mean
The harmonic mean is a type of numerical average. It is calculated by dividing the

number of observations by the reciprocal of each number in the series. Thus, the
harmonic mean is the reciprocal of the arithmetic mean of the reciprocals. The
harmonic mean always shows the lowest value among the Pythagorean means.
The harmonic mean is often used to calculate the average of the ratios or rates. It
is the most appropriate measure for ratios and rates because it equalizes the
weights of each data point. In finance, the harmonic mean is used to determine the
average for financial multiples such as the price-to-earnings (P/E) ratio.
Formula for Harmonic Mean

The general formula for calculating a harmonic mean is:
Harmonic mean = n / (∑1/x_i)
Where:
n = the number of the values in a dataset
x_i = the point in a dataset
The weighted harmonic mean can be calculated using the following formula:
Weighted Harmonic Mean = (∑w_i ) / (∑w_i/x_i)
Where:
w_i = the weight of the data point
x_i = the point in a dataset
Example of Harmonic Mean:

You are a stock analyst in an investment bank. Your manager asked you to
determine the P/E ratio of the index of the stocks of Company A and
Company B. Company A reports a market capitalization of P2 billion and
earnings of P20 million, while Company B reports a market capitalization
of P20 billion and earnings of P4 billion. The index consists of 40% of
Company A and 60% of Company B.
SOLUTION:
Firstly, we need to find the P/E ratios of each company. Remember that
the P/E ratio is essentially the market capitalization divided by the
earnings.
P/E (Company A) = (P2 billion) / (P20 million) = 100
P/E (Company B) = (P20 billion) / (P4 billion) = 5
We must use the weighted harmonic mean to calculate the P/E ratio of the
index. Using the formula for the weighted harmonic mean, the P/E ratio of
the index can be found in the following way:
P/E (Index) = (0.4+0.6) / (0.4/100 + 0.6/5) =
P/E (Index) = 1 / (0.004 + 0.12) =
P/E (Index) = 1 / 0.124 = 8.06
2. Arithmetic mean
The arithmetic mean is the average of a sum of numbers, which reflects the
central tendency of the position of the numbers. It is often used as a parameter in
statistical distributions or as a result to summarize the observations of an
experiment or a survey.
To calculate the arithmetic mean, add a collection of numbers and divide the sum
by the count of the numbers in that collection. The mathematical expression is
given below:
Where:
ai – The value of the ith observation
n – The number of observations
As its formula shows, the arithmetic mean measures every observation value
equally, so it is also known as an unweighted average or equally-weighted
average.
EXAMPLE:
The closing prices of a stock for the last five days are collected respectively: P91,
P89, P83, P90, and P92.
SOLUTION:
(91 + 89 + 83 + 90 + 92) / 5 =
445 / 5 = 89
The arithmetic mean of the stock price is, thus, P89.
3. Geometric mean
The geometric mean is the average growth of an investment computed by
multiplying n variables and then taking the nth –root. In other words, it is the
average return of an investment over time, a metric used to evaluate the
performance of a single investment or an investment portfolio.
Geometric Mean Formula for Investments
Geometric Mean = [Product of (1 + Rn)] ^ (1/n) -1
Where:
Rn = growth rate for year N
Year Starting Equity Return % Return $ Closing equity
1 1,000 5% 50 1,050
2 1,050 10% 105 1,155
3 1,155 20% 231 1,386
4 1,386 50% 693 2079
5 2079 20% 415.8 2494.8

The actual 5 year return on the account is:
(P2494.8 – P1,000)/P1,000 =
P1494.8 / P1,000 = 1.49%
4. Decision tree analysis
Decision tree analysis is a powerful decision-making tool which initiates a

structured nonparametric approach for problem-solving. It facilitates the
evaluation and comparison of the various options and their results, as shown in a
decision tree. It helps to choose the most competitive alternative. It is a widely
used technique for taking crucial decisions like project selection, cost
management, operations management, production method, and to deal with
various other strategic issues in an organization.
EXAMPLE:
ABC Ltd. is a company manufacturing skincare products. It was found that the
business is at the maturity stage, demanding some change. After rigorous
research, management came up with the following decision tree:
In the above decision tree, we can easily make out that the company can expand its
existing unit or innovate a new product, i.e., shower gel or make no changes.
SOLUTION:
Option 1: Expansion of Business Unit:
If the company invests in the development of its business unit, there can be two possibilities, i.e.:
 40% possibility that the market share will hike, increasing the overall profitability of the
company by ₹2500000;
 60% possibility that the competitors would take over the market share and the company
may incur a loss of ₹800000.
To find out the viability of this option, let us compute its EMV (Expected Monetary Value):
Option 2: New Product Line of Shower Gel:
If the organization go for new product development, there can be following two possibilities:
 50% chances are that the project would be successful and yield ₹1800000 as profit;
 50% possibility of failure persists, leading to a loss of ₹800000.
To determine the profitability of this idea, let us evaluate its EMV:
Option 3: Do Nothing:
If the company does not take any step, still there can be two outcomes, discussed below:
 40% chances are there that yet, the organization can attract new customers, generating a
profit of ₹1000000;
 60% chances of failure are there due to the new competitors, incurring a loss of ₹400000.
Given below is the EMV in such circumstances:
CONCLUSION:
From the above evaluation, we can easily make out that the option of a new product line
has the highest EMV. Therefore, we can say that the company can avail this opportunity
to make the highest gain by ensuring the best possible use of its resources.

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Assignment:

The harmonic mean is a type of numerical average. It is calculated by dividing the

Formula for Harmonic Mean

Example of Harmonic Mean:

Year Starting Equity Return % Return $ Closing equity

2 1,050 10% 105 1,155

3 1,155 20% 231 1,386

4 1,386 50% 693 2079

5 2079 20% 415.8 2494.8

4. Decision tree analysis

Decision tree analysis is a powerful decision-making tool which initiates a

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