What is Beta in Finance?
The beta in finance is a financial metric that measures how sensitive is the stock price with respect to the change in the market price (index). The Beta is used for measuring the systematic risks associated with the specific investment. In statistics, beta is the slope of the line which is obtained by regressing the returns of stock return with that of the market return
Beta is mainly used in calculating CAPM (Capital Asset Pricing Model). This model calculates the expected return on an asset using expected market returns and beta. CAPM is mainly used in calculating the cost of equity. These measures are very important in the valuation method of DCF.
Beta in Finance Formula
The CAPM formula uses Beta as per the below formula –
- Risk-free rates are usually government bonds. For example in the UK and US, 10-year government bonds are used as risk-free rates. This return is the one that an investor expects to gain by investing in a completely risk-free investment.
- Beta is the degree in which the company’s equity returns vary in comparison to the overall market.
- Risk Premium is given to the investor for taking on additional risk by investing in that stock. Since the risk from investing in the risk-free bond is much less than that of the equities, investors expect a higher return to take on higher risk.
Beta in Finance Interpretation
- If Beta = 1: If Beta of the stock was equal to one, this means that the stock has the same level of risk as to the stock market. If the market rises by 1% the stock will also rise by 1% and if the market comes down by 1% the stock will also come down by 1%.
- If Beta > 1: If the Beta of the stock is greater than one, then it implies a higher level of risk and volatility as compared to the stock market. Though the direction of the stock price change will be the same, however, the stock price movements will be rather extremes.
- If Beta >0 and Beta<1: If the Beta of the stock is less than one and greater than zero, it implies the stock prices will move with the overall market, however, the stock prices will remain less risky and volatile.
Calculation of Beta in Finance
The beta of a security is calculated as the covariance between the return of the market and the return on security divided by the variance of the market
Beta of Apple = 0.032/0.015 = 2.13
#2-Standard Deviation and Correlation Method
Beta can also be calculated by dividing –
- Standard Deviation of the return of the securities divided by the standard deviation of the returns of the benchmark.
- This value is then multiplied by the correlation of the market and securities returns.
An investor is looking to invest in Amazon but was worried about the volatility of the stock. He, therefore, decided to calculate Beta for Amazon in comparison to the S&P 500. Based on the past data, he found out that the correlation between the S&P 500 and Amazon is 0.83. Amazon has a standard deviation of returns of 23.42% while S&P 500 has a standard deviation of 32.21%
Beta = 0.83 x (23.42% divided by 32.21%)= 0.60
The beta for the market is 1 while for Amazon is 0.60. This indicates that the beta for Amazon is lower than the market and it means that the stock has experienced 40% less volatility than the market.
How to Calculate Beta in Excel?
Below are the steps used to calculate Beta in excel. It can be easily calculated using the excel slope function –
Step 1: Get the weekly/monthly/quarterly prices of the stock
Step 2: Get the weekly/monthly/quarterly prices of the index
Step 3: Calculate the weekly/monthly/quarterly returns of the stock
Step 4: Calculate the weekly/monthly/quarterly returns of the market
Step 5: Use the slope function and select the return of the market and the stock
Step 6: The output of the slope is Beta
In the above example, we have calculated beta using the above steps. Return is calculated by dividing the old price and the new price and subtracting one from it and multiplying by a hundred.
These price returns are then used in calculating the slope function. The beta of the stock in comparison to the market comes to 1.207. This means that the stock is more volatile than the market.
Advantages of Beta in Finance
- Valuation: The most popular use of a beta is to calculate the cost of equity while conducting valuations. The CAPM uses beta to calculate the systematic risk of the market. In general, this can be used to value a lot of companies with various capital structures.
- Volatility: Beta is a single measure which helps the investors to understand stock volatility in comparison to the market. This helps the portfolio managers in assessing the decisions regarding the addition, deletion of the security from his portfolio.
- Systematic Risk: Beta is a measure of systematic risk. Most of the portfolios have unsystematic risk eliminated from the portfolio. Beta only considers systematic risk and thereby provides the real picture of the portfolio.
Disadvantages of Beta in Finance
- Beta can help to assess systematic risk. However, it does not guarantee future returns. Beta can be calculated at various frequencies including two months, six months, five years, etc. Using the past data cannot hold true for the future. This makes it difficult for the user to predict the stock’s future movements.
- Beta is calculated based on the stock prices in comparison to the market prices. Therefore for startups or for private companies, it is difficult to calculate beta. There are methods like unleveraged beta and leveraged betas but that also requires a lot of assumptions to be made.
- One another drawback is that beta cannot tell the difference between an upswing and a downswing. It does not tell us when the stock was more volatile.
This has been a guide to Beta in Finance and its definition. Here we discuss the calculation of Beta in Finance using its formula and examples along with its interpretation, advantages, and disadvantages. You may learn more about Corporate Finance from the following articles –