What is Beta Coefficient?
The beta coefficient formula is a financial metric that measures how likely the price of a stock/security will change in relation to the movement in the market price. The Beta of the stock/security is also used for measuring the systematic risks associated with the specific investment.
The beta is the degree of change in the outcome variable for every 1 unit change in the predictor variable. A standardized beta compares the strength of the effect of each individual independent variable to the dependent variable. The greater the absolute value of the beta coefficient, the stronger will be the impact.
The beta formula is used in the CAPM model to calculate the Cost of EquityCalculate The Cost Of EquityCost of Equity (Ke) is what shareholders expect for investing their equity into the firm. Cost of equity = Risk free rate of return + Beta * (market rate of return - risk free rate of return). as shown below –
Cost of Equity = Risk Free Rate + Beta x Risk Premium
Beta Coefficient Meaning
The Beta is calculated in the CAPM modelCAPM ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market. (Capital Asset Pricing Model) for calculating the rate of return of a stock or portfolio.
The Beta calculation in excel is a form analysis since it represents the slope of the security’s characteristic line, i.e., a straight line indicating the relationship between the rate of return on a stock and the return from the market. This can further be ascertained with the help of the below Beta formula:
β = Covariance of Market Return with Stock Return / Variance of Market Return
The meanings of beta coefficient –
- If the coefficient is 1 it indicates the price of the stock /security is moving in line with the market.
- If coefficient <1; the return of the security is less likely to respond to the market movements
- If the coefficient > 1, the returns from the security are more likely to respond to market movements, thereby also making it volatile;
Beta Coefficient Example
If Apple Inc’s (AAPL) beta is 1.46, it indicates that the stock is highly volatile and is 46% more likely to respond to movement in the markets. On the other hand, say Coca-Cola has a β coefficient of 0.77, indicating the stocks are less volatile and 23% less likely to respond towards movement in the market.
As a trend, it has been observed that utility stock has a CAPM Beta CAPM Beta CAPM Beta is an essential theoretical measure of how a single stock moves with respect to the market. In this method, we determine the cost of equity by summing up the beta and risk premium product with the risk-free rate.of less than 1. On the other hand, technology stocks have a Beta coefficient of greater than 1, indicating a likelihood of higher returns with more associated risks.
Beta Coefficient Calculation
Here we will take an example to calculate the beta of MakeMyTrip (MMTY) and the Market index as NASDAQ.
You may download the fully solved Beta Calculation Excel Worksheet from here.
There are three Beta formulas – variance/covariance method, slope function in excel, and regression formula. We will see each of the beta coefficient formulae below –
Step 1 – Download Historical prices and NASDAQ index data from the past 3 years
I have downloaded the data from yahoo finance.
- For the NASDAQ dataset, please visit this link Yahoo Finance.
- For Makemytrip prices, please visit this URL here.
Step 2 – Sort the Prices as given below
Sort the dates and adjusted closing prices in the ascending order of dates. You can delete the remaining columns as we don’t need those for beta calculations in excel.
Step 3 – Prepare the beta coefficient excel sheet as per below.
Step 4 – Calculate Daily Returns
Return = [Closing share price – Opening share price] / Opening Share Price
Step 5 – Calculate Beta Formula using the Variance-Covariance method
In this, you need to use the two formulas (variance and covariance in excel), as shown below.
Using the variance-covariance method, we get the Beta as 0.9859 (Beta Coefficient)
Step 6 – Calculate Beta using SLOPE Function in excel
Using this SLOPE function in excel , we again get the Beta as 0.9859 (Beta Coefficient)
Step 7 – Calculate Beta Coefficient Regression
If you are unable to locate Data Analysis in Excel, then you need to install the Analysis ToolPak. This process is relatively easy: Go to FILE -> Options -> Add-Ins -> Analysis ToolPakAnalysis ToolPakExcel's data analysis toolpak can be used by users to perform data analysis and other important calculations. It can be manually enabled from the addins section of the files tab by clicking on manage addins, and then checking analysis toolpak. -> Go -> Check Analysis ToolPak -> OK
Select Data Analysis and click on Regression
Choose the Y Input Range and X Input Range
Once you click OK, you get the following Summary Output.
You will get the same Beta in each of the three methods.
Advantages of Beta Coefficient Regression
The following are some of the advantages of Beta regression:
- It is used for beta regression is to estimate the Cost of EquityCost Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns. in Valuation models. CAPM estimates an asset’s Beta based on the systematic riskSystematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”. of the market. The cost of equity derived by the CAPM reflects a reality through which how investors have diversified their portfolios for reducing the impact of the unsystematic risksUnsystematic RisksUnsystematic risk refers to risk that is generated in a specific company or industry and may not be applicable to other industries or the economy as a whole. There are two types of unsystematic risk: business risk and financial risk..
- It offers an easy to use beta calculation in excel, which standardizes a risk measure across multiple firms with varied capital structures and fundamentals.
Disadvantages of Beta Coefficient Regression
The following are some of the disadvantages of Beta regression:
- There is a heavy reliance on past returns and does not consider updated information/other factors that can impact the returns in the future.
- Beta regression as more return is garnered, the measure of Beta changes, and so will the cost of equity.
- Though systematic risks are inherentRisks Are InherentInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization. to the market in explaining asset returns, the portion of unsystematic risks is ignored.
A negative beta formula means an investment that moves in the opposite direction against the stock market. When the market rises, the negative beta tends to fall down, and when the market falls, the negative-beta will tend to rise. This is generally true for gold stocks and gold bullion. Since Gold is a more secure store of value than currency, a crash in the market prompts investors to liquidate their stocks and convert into currency (for zero betas) or purchase gold in case of a negative beta coefficient.
A negative beta is not highlighting the fact that there is an absence of risk, but it means that the investment offers a hedge against an unforeseen market downturn. However, if the market continues to rise, a negative-beta coefficient strategy is losing money through opportunity risk (loss of a specific chance to earn higher returns) and also inflation riskInflation RiskInflation Risk is a situation where the purchasing power drops drastically. It could also be explained as a situation where the prices of goods and services increase more than expected. Inflation Risk is also known as Purchasing Power Risk. (rate of return not keeping pace with the prevailing inflation in the country).
Beta Coefficient Video
This article has been a guide to Beta Coefficient, formulas, and calculations. Here we calculate beta in excel of MakeMyTrip using three methods – Variance-Covariance, SLOPE Function, and Regression Function. You may also have a look at these other recommended articles to learn more about valuations –