Beta in Finance

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 PricingCapital Asset PricingThe 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 more 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 –

Cost of Equity = Risk-Free Rate + Beta x Risk Premium

Beta in Finance

  • 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

Beta in Finance

  • If Beta = 1: If the 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

#1-Variance-Covariance Method

The beta of a security is calculated as the covarianceCovarianceCovariance is a statistical measure used to find the relationship between two assets and is calculated as the standard deviation of the return of the two assets multiplied by its correlation. If it gives a positive number then the assets are said to have positive covariance i.e. when the returns of one asset goes up, the return of second assets also goes up and vice versa for negative more between the return of the market and the return on security divided by the variance of the market

Beta = Covariance of the Market and the Security/ Variance of the Security
Let’s assume a portfolio manager wants to calculate beta for Apple incorporation and wants to include it in its portfolio. He decides to calculate it against its benchmark, the S&P 500. Based on the past years data, Apple incorporation and S&P has a covariance of 0.032, and the variance of S&P is 0.015

Calculate Beta for Apple 1

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%

Calculate Beta for Amazon

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. It 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.

prices of the stock calculation 1

Step 2: Get the weekly/monthly/quarterly prices of the index.

prices of the index calculation 2

Step 3: Calculate the weekly/monthly/quarterly returns of the stock.

returns of the stock calculation 3

Step 4: Calculate the weekly/monthly/quarterly returns of the market.

returns of the market calculation 4

Step 5: Use the slope function and select the return of the market and the stock

Beta calculation 5

Step 6: The output of the slope is Beta

Beta calculation 6

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. It means that the stock is more volatile than the market.

Advantages of Beta in Finance

Disadvantages of Beta in Finance

Recommended Articles

This article 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 –

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