Students get their first taste of the proverbial “stuck between a rock and a hard place” when the concept of beta is introduced in their corporate finance classes wherein working with financial models using this metric is commonplace. Beta and the Time Value of Money are two concepts that comprise the heart of finance. Needless to say, a thorough understanding of these two topics is of prime importance to anyone considering a career in finance. This article is written to demystify the cloud of despair and confusion that students associate with beta. Having read this article, you may be well on your way to searching for the beta value of your preferred stocks trading on a given international stock exchange.
What is beta?
Beta is a term that is both ubiquitous and copious in reference when the financial markets are discussed. Although beta is an abstract concept for many, it is nonetheless a useful metric that helps measure the sensitivity of a given stock, or unit of ownership in a company. While beta is widely used to discuss volatility, its applications in the real world have vital implications for investors.
Let us hypothetically state that your grandmother comes over to you one morning and says that she wants her little Johnny to help her invest a portion of her life savings in the stock market. We can safely assume, for those of us who are less industrious, that your grandmother’s portfolio would be risk averse and that you may opt for investments akin to zero coupon bonds, T-bills, government securities, etc. The beta, or volatility, of these types of investments has a value of zero. What does zero beta mean? If you think about a timeline with zero in the middle and negative numbers to the left and positive numbers to the right, you may assume that zero indicates neutrality. Not in the world of finance, my friends!
- A beta of zero simply means that the market could come crashing down but your grandmother’s incremental returns would not be affected because the Federal Reserve can simply print more money (Ex: Quantitative easing 1, 2 and presently 3).
- A beta of 1 indicates that the stock is expected to perform in accordance with the market and can be described as market neutral at best. If the stock market performs well, stocks with a beta of 1 are generally expected to follow in the same direction. If 0 indicates a risk-free investment and 1 indicates market neutral then what does a stock with a beta of a given positive or negative number indicate?
- A positive value simply means that there is a positive correlation between the stock market and the performance of your stock and a negative value refers to an inverse correlation between the two.
Please give me an example
Fair enough! Assume that you invest your money in the stock of a company whose mission statement resonates with you. The stock has a beta of 1 and is considered to be market neutral. If the stock market goes up by 100 bps, your stock will also move up by 100 bps. Let’s assume however, that your stock has a beta of -0.25. This implies that your stock is 25 percent more risky than the market. If the market goes up by 100 bps, your stock, which is inversely correlated to the stock market because of the negative sign, will fall by 25 bps. Why would anyone focus on a stock with negative beta? It is not uncommon for investors to look for stocks that have a negative beta to look for an opportunity to begin “shorting” the stock. However, do keep in mind that it is not necessary for a stock to have a negative beta for your short position to be effective.
Why do I need to know about it?
Beta can affect your portfolio in more ways than one. How, you may ask? Well, not only does it bring your attention to your risk appetite, it also has the ability to help you combat adverse market conditions by giving an indication of how the stock you have invested in is likely to perform given changing market conditions.
How reliable is it?
Since beta relies on historical data, analysts often use the patterns derived from the original data set to make projections into how the stock will behave in dynamic market situations. However, do keep in mind that history does not necessarily repeat itself. While patterns may come to our rescue when predicting volatility, the measurement of beta is never 100 percent accurate. Interestingly enough, if you and I were to sit down and calculate beta with the same set of data, it should come as no surprise to you if the numbers are slightly different. (Hence, it is important to remember that your sample size for beta analysis is key)
keep in mind that since beta relies on historical data, it is not an efficient tool to utilize to predict whether a new pharmaceutical drug that has received FDA approval will be a beneficial investment since historical data for this particular scenario does not exist.
- Can you think of examples of your own? (Think: Mergers and Acquisitions, growth potential of a company’s stock that has just entered the market, etc)
Where can I look it up?
Yahoo finance for the win! Simply type finance.yahoo.com in the World Wide Web and enter the ticker of a stock that catches your interest. Yahoo finance can be accessed by anyone and is a free resource that is available for various data points and stock indicators as well. For those that are slightly more industrious, other helpful resources that come at a small fee are Reuters, Bloomberg, etc.
How is it calculated?
Beta is calculated via regression analysis and relies primarily on historical data. Historical data refers to information that has been aggregated and derived in a given time period (1 to 3 years is often the standard period of time).
What if it is not available readily?
Finding the beta of a publicly traded stock is fairly easy given the vast reserves of information available in public domain. However, the challenge presents itself when one attempts to value beta for a private stock. Yahoo finance certainly does not answer your problem directly, but serves as an effective starting point. The first step is often looking for comparable companies in the same sector. The closer you can get to finding a similar stock comparison, the more reliable your beta will be. However, do keep in mind that the capital structure of a company can differ despite a myriad of similarities. In order to value beta accurately, one must unlever and then relever the beta.
Unlevering and relevering is a lot like changing clothes. Suppose that you do not like the orange colored shirt and light blue jeans you are wearing. Easy! Simply change your attire and replace the contents with more suitable clothes. Similarly, a company’s capital structure (debt vs equity) can be unlevered (removed) and relevered (changed according to the capital structure composition) Moreover the value assigned to beta also takes into account various systematic and unsystematic risks associated with a given company. Systematic risk is an ornate way of saying market risk and unsystematic risk is industry specific. When beta is unlevered and relevered, industry risk is not relevant since one assumes that the stock of the publicly traded counterpart is also in the same industry and faces the same risks.
In a nutshell, beta is the starting point for any calculation related to the capital asset pricing model (CAPM) and portfolio management.
Beta → CAPM → Weighted Average Cost of Capital → Discounted Cash Flow Analysis
Beta → volatility/risk related to a given stock → risk appetite = main determinant of a portfolioblog comments powered by Disqus