Beta

What Is Beta?

An investment security's (i.e., a stock's) beta (β) is a gauge of its return volatility concerning the total market. It is a crucial capital asset pricing model (CAPM) component utilized as a risk indicator. A higher β means greater risk and higher projected profits for the firm.

For investors, a β is a crucial number for assessing the risk of a stock. It gives insight into how much a stock's price swings in reaction to market fluctuations by contrasting its price movements with those of the entire market.

A β rating of one shows that the stock moves in lockstep with the market. If the market moves by a specific amount, the stock is anticipated to follow suit.

If the β number is less than one, the stock is less volatile than the market. It signifies that the stock's price moves less than the market's price. In terms of market swings, such stocks are seen as less hazardous.

A β rating greater than one suggests that the stock is more volatile than the market as a whole. It signifies that the stock's price has bigger volatility than the market. These are considered risky investments.

It's vital to remember that because β depends on previous data, investment selections should also consider the company's financial health and market trends.

Despite its limitations, β is still a useful tool for investors to evaluate the risks and possible rewards associated with a company.

Examples of Beta

The below examples show how β values can help you understand the link between a stock's price changes and general market movements. Remember that β is a historical metric and may not correctly predict future performance. Some examples of β are:

1. High β: A company's volatility exceeds the market's when it has a value greater than 1. A high-risk technology business, for instance, with a β of 1.95, would have earned 195% of the market's return over a specific period (usually assessed weekly).
2. Low β: A firm with a volatility index (β) below 1 is less volatile than the entire market. Consider an electric utility firm with a β of 0.55 as an illustration. Its returns would have been just 56% of the market's returns for the same period.
3. Negative β: A corporation with a negative β has a negative correlation with market returns. When the market was up 10%, a gold business, for instance, with a -0.4, would have returned -4%.

Calculation Of Beta

A stock's beta (β) measures its sensitivity to market movements. It indicates how much the stock's Price typically moves in response to changes in the overall market.

To calculate β, you'll need historical price data for the stock and a benchmark index (often a broad market index such as the S&P 500, NIFTY, or Dow Jones) simultaneously. The following is the formula for calculating β:

Beta = Covariance (Returns on stock, Returns on Market) / Variance(Returns on market)

There are a few steps to calculate β. They are:

Step 1: Collect Historical Data

Download historical security prices for the asset's β you want to calculate. Download historical security prices for the benchmark index. (such as the S&P 500, NIFTY, or Dow Jones). You'll need at least two years of data to get useful results.

Step 2: Calculate Returns

Calculate the daily or monthly returns for the stock and the benchmark index. The return is calculated as follows:

Return = (Current Price - Previous Price) / Previous Price

Step 3: Calculate Covariance

To compute the covariance, you need to gather data like returns on stock and benchmark index returns. The formula is:

Covariance = Σ ([Returns on Stock - Average Return on Stock] * [Returns on Market - Average Return on Market]) / [Number of observations - 1]

Step 4: Calculate Variance

Calculate the variance of the benchmark index returns using the formula:

Variance = Σ (Returns from the Market - Average Return from the market)² / (Number of Observations - 1)

Step 5: Calculate Beta

Last, compute the β using the covariance and variance:

Beta = Covariance / Variance

Interpreting Beta

Understanding an asset's risk and return characteristics about the general market requires investors and analysts to interpret β. Some important considerations to remember while analyzing β:

1. β = 1: If an asset's β is exactly one, its price fluctuations are predicted to follow the market closely. This signifies that the asset is risky in comparison to the wider market.
2. β > 1: The asset is expected to be more volatile than the market. In other words, when compared to the market, the asset's price swings are likely to be exaggerated. A higher β suggests a higher level of risk and the possibility of bigger rewards during market upswings.
3. β < 1: A β of less than one indicates that the asset is expected to be less volatile than the market. The asset's price movements are expected to be less intense than the market's. A lower β suggests lower risk but also lower potential returns during market upswings.
4. β = 0: If the β is 0, the asset's price movements are uncorrelated with the market's movements. In this case, the asset's returns are independent of the overall market performance.
5. Negative β: A negative β suggests that the asset's returns move opposite the market's. It means the asset performs well when the market is down and vice versa. Negative β assets can act as hedges in a diversified portfolio.

Comparing Betas

When comparing betas of various assets, a larger β indicates greater risk and possible returns than the market, whereas a lower β indicates less risk and potential returns.

It's vital to remember that β is based on prior performance, which may or may not properly forecast future moves. Furthermore, β is only one of several aspects to consider when assessing an investment.

Other aspects to examine while making investment selections include the company's financial health, industry developments, and general market circumstances.

For instance, the Dow Jones Industrial Average, which focuses on technology, would be more appropriate when analyzing a technology stock than the S&P 500, which represents a broader market.

What are Equity Beta and Asset Beta?

Two different β measures are used in finance to assess an investment's risk: Asset Beta and Equity Beta. Both betas are employed in the capital asset pricing model (CAPM) to predict an asset's expected return based on its sensitivity to market fluctuations.

Asset Beta

Asset β, also known as unlevered β or business β, measures the sensitivity of the overall risk of a company's assets to market movements. It reflects the risk of the company's core business operations and ignores the influence of its capital structure (Debt and equity mix). 

Asset β is typically calculated for the entire firm, considering its assets and business segments. The formula to calculate asset β is as follows:

Asset β = Covariance (Asset Returns, Market Returns) / Variance(Market Returns)

• Covariance (Asset Returns, Market Returns) is the covariance between the returns of the company's assets and the market returns.
• Variance (Market Returns) is the variance of the market returns.

Equity Beta

Equity β, also known as levered β or share β, measures the sensitivity of a company's equity (shares) risk to market movements. It considers the company's capital structure, including debt and equity. 

Equity β is relevant to equity investors since it shows the risk of holding the company's stock.

The formula to calculate equity β  is as follows:

Equity β = Asset β * (1 + [1 - Tax Rate] * [Total Debt / Equity])

• Asset β is the previously calculated β for the company's assets.
• The corporate tax rate is the tax rate.
• The total outstanding debt of the company is total debt.
• The market value of the company's equity is equity (market capitalization).

Asset β assesses the risk of a company's overall operations while ignoring the influence of its capital structure.

Equity β assesses the risk of a company's equity by considering the impact of debt and capital structure on the stock.

Levered Beta vs. Unlevered Beta

Levered β and unlevered β are terms used in finance to describe how risky an asset is relative to the market as a whole, usually a stock or firm. They aid analysts and investors in comprehending how changes in a company's capital structure affect its risk profile.

Unlevered Beta

Also known as asset β, it gauges the risk associated with an asset on the assumption that it is debt-free (or unleveraged).

It is impacted by market circumstances, business fundamentals, and industry dynamics and shows the inherent risk of the company's basic business activities.

Calculate unlevered β by using the formula,

Unlevered β = Levered β / [(1 + (1 – Tax Rate) * (Debt / Equity)]

Unlevered β is frequently used to compare the risk of several businesses or projects in the same sector, independent of capital arrangements. It offers a fundamental gauge of systemic risk unaffected by financial leverage.

Levered Beta

Levered β, sometimes called equity β, assesses an asset's risk considering the impact of its financial leverage. It considers the company's debt and how it affects the equity's general level of risk. 

Leveraged β is often greater than unlevered β as a corporation takes on additional debt. It is because debt makes changes in a company's earnings more pronounced, influencing its stock price volatility. 

Calculate Levered β by using the formula,

Levered β = Unlevered β * [(1 + (1 – Tax Rate) * (Debt / Equity)]

Levered β is more pertinent for determining the risk of an equity investment in a particular firm, especially when considering the implications of debt financing.

Researched and authored by Sethuraman | LinkedIn

Reviewed and edited by Alexander Bellucci | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Levered Beta

• The Ultimate Cash Flow Guide (EBITDA, CF, FCF, FCFE, FCFF)

• Types of Valuation Multiples

• Unlevered Beta / Asset Beta

• Unlevered Cost of Capital