Valuation Tutorials

- Valuation Basics
- Discounted Cash Flows
- Dividend Discount Model (DDM)
- Gordon Growth Model
- Discounted Cash Flow Analysis (DCF)
- Free Cash Flow to Firm (FCFF)
- Free Cash Flow to Equity (FCFE)
- Terminal Value
- Cost of Equity
- CAPM Beta
- Calculate Beta Coefficient
- Market Risk Premium
- Weighted Average Cost of Capital (WACC)
- Security Market Line (SML)
- Free Cash Flow (FCF)
- Free Cash Flow Yield (FCFY)
- Mistakes in DCF
- Treasury Stock Method
- CAPM Formula
- Cash Flow vs Free Cash Flow

- Valuation Multiples
- Equity Value vs Enterprise Value
- Trading Multiples
- Comparable Company Analysis
- Transaction Multiples
- (Price Earning Ratio (P/E)
- Price to Cash Flow (P/CF)
- Price to Book Value Ratio (P/B)
- Price Earning Growth Ratio (PEG)
- Trailing PE vs Forward PE
- Forward PE
- EV to EBITDA Multiple
- EV to EBIT Ratio
- EV to Sales Ratio
- EV to Assets

- Other Valuation Tools
- Valuation Interview Prep

**CAPM Beta –**When we invest in stock markets, how do we know that stock A is less risky than stock B. Differences can arise due due to the market capitalization, revenue size, sector, growth, management etc. Can we find a single measure which tells us that which stock is more risky? The answer is YES and we call this as CAPM Beta or Capital Asset Pricing Model Beta.

In this article, we look at the nuts and bolts of CAPM Beta –

- CAPM Beta Definition
- CAPM Beta Formula
- What is Beta?
- Key Determinants of Beta
- High Beta Stocks/Sectors
- Low Beta Stock/Sectors
- CAPM Beta Calculation in Excel
- Levered vs Unlevered Beta
- How to calculate beta of unlisted or private firms
- Negative Beta? Examples
- Advantages of CAPM Beta
- Disadvantages of CAPM Beta

## CAPM Beta Definition

Investopedia defines beta as

A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole

Beta is a very important measure that is used as a key input for Discounted Cash Flow or DCF valuations.

If you wish to learn about DCF Modeling professionally, I have created a 117 course portfolio on Investment Banking. You may want to have a look at this Investment Banking Course here.

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## CAPM Beta Formula

If you have a slightest of the hint regarding DCF, then you would have heard about Capital Asset Pricing Model (CAPM) that calculates Cost of Equity as per the below Beta formula.

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

If you have not heard of Beta yet, then worry not. this article explains you about Beta in most basic way.

Let us take an example: when we invest in stocks, it is but human to pick stocks that have the highest possible returns. However, if one chases only returns, the other corresponding element is missed i.e. **Risk.**

Actually, every stock is exposed to two types of risks

**Non-Systematic Risks**include risks that are specific to a company or industry. This kind of risk can be eliminated through diversification across sectors and companies. . The effect of diversification is that the diversifiable risks of various equities can offset each other.**Systematic Risks**are those risks that affect the overall stock markets. Systematic risks can’t be mitigated through diversification but can be well understood via an important risk measure called as**“BETA”**

## What is Beta?

Basic Definition of Beta – **Beta measures the stock risks in relation to the overall market.**

**If Beta = 1:**If Beta of the stock is one, then it has the same level of risk as the stock market. Hence, if stock market (NASDAQ and NYSE etc) rises up by 1%, the stock price will also move up by 1%. If the stock market moves down by 1%, the stock price will also move down by 1%.**If Beta > 1:**If the Beta of the stock is greater than one, then it implies higher level of risk and volatility as compared to the stock market. Though the direction of the stock price change will be same, however, the stock price movements will be rather extremes. For example, assume the Beta of the ABC stock is two, then if stock market moves up by 1%, the stock price of ABC will move up by two percent (higher returns in the rising market). However, if the stock market moves down by 1%, the stock price of ABC will move down by two percent (thereby signifying higher downside and risk).**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. For example, if the beta of the stock XYZ is 0.5, it means if the overall market moves up or down by 1%, XYZ stock price will show a an increase or decrease of only 0.5% (less volatile)

In general, large companies with more predictable Financial Statements and profitability will have a lower beta value. For example, Energy, Utilities and Banks etc, all tend to have lower beta. Most betas normally fall between 0.1 and 2.0 though negative and higher numbers are possible.

## Key Determinants of Beta

Now that we understood Beta as a measure of Risk, it is important for us to also understand the sources of risks. Beta depends on lot of factors – usually the nature of business, operating and financial leverages etc.

Below diagram shows the key determinants of Beta –

**Nature of Business –**The beta value for a firm depends on the kind of**products and services offered**and its relationship with the overall marco-economic environment. Note that Cyclical companies have higher betas than non-cyclical firms firms. Also, discretionary product firms will have higher betas than firms that sell less discretionary products**Operating leverage:**The greater the proportion of fixed costs in the cost structure of the business, the higher the beta**Financial leverage:**The more debt a firm takes on, the higher the beta will be of the equity in that business. Debt creates a fixed cost, interest expenses, that increases exposure to market risks

## High Beta Stocks/Sectors

Due to uncertain economic environment, questions always remain on what is the best investment strategy. Should I pick high CAPM Beta stocks or Low CAPM Beta Stocks. It is normally understood that cyclical stocks have high Beta and defensive sectors have low Beta.

Cyclical stocks are those whose business performance and stock performance is highly correlated with the economic activities. If the economy is in recession, then these stock exhibit poor results and thereby stock performance takes a beating. Likewise, if the economic is on a high growth trajectory, cyclical stocks tend to be highly correlated and demonstrate high growth rate in business and stock performances.

Take for example, General Motors, its CAPM Beta is 1.43. This implies if the stock market moves up by 5%, then General Motors stock will move up by 5 x 1.43 = 7.15%.

Following sectors can be classified as cyclical sectors and tend to exhibit High Stock Betas.

- Automobiles Sector
- Materials Sector
- Information Technology Sector
- Consumer Discretionary Sector
- Industrial Sector
- Banking Sector

## Low Beta Stocks/Sectors

Low Beta is demonstrated by stocks in defensive sector. Defensive stocks are stocks whose business activities and stock prices are not correlated with the economic activities. Even if the economy is in recession, these stocks tend to show stable revenues and stock prices. For example PepsiCo, its stock beta is 0.78. If the stock market moves down by 5%, then Pepsico stock will only move down by 0.78×5 = 3.9%.

Following sectors can be classified as defensive sectors and tend to exhibit Low Stock Betas-

- Consumer Staples
- Beverages
- HealthCare
- Telecom
- Utilities

## CAPM Beta Calculation in Excel

Technically speaking, Beta is a measure of stock price variability in relation to the overall stock market (NYSE, NASDAQ etc). **Beta is calculated by regressing the percentage change in stock prices versus the percentage change in the overall stock market. **CAPM Beta calculation can be done very easily on excel.

Let us calculate Beta of MakeMyTrip (MMTY) and Market Index as NASDAQ

**Step 1 – Download the Stock Prices & Index Data for Past 3 years **

The first step is to download the stock price and Index data. For NASDAQ, download the dataset from Yahoo Finance

Likewise, download the corresponding stock price data for MakeMyTrip example from here.

**Step 2 – Sort the Dates & Adjusted Closing Prices**

Once you have downloaded the data set for the two, please do the following for each of the data set-

- Sort the dates and Adjusted Closing prices in ascending order
- Delete Open, High, Low, Close & Volume Column. They are not required for Beta Calculations.

##### Step 3 – Prepare a single sheet of Stock Prices Data & Index Data

##### Step 4 – Calculate the Fractional Daily Return

##### Step 5 – Calculate Beta – Three Methods

You can use either of the three methods to calculate Beta – 1) Variance/Covariance Method 2) SLOPE Function 3) Data Regression

**Variance / Covariance Method**

Using the variance covariance method we get the **Beta as 0.9859 (Beta Coefficient)**

**SLOPE function in excel**

Using this SLOPE function method, we again get the **Beta as 0.9859 (Beta Coefficient)**

**3rd Method – Using Data Regression**

For using this function in excel, you need to go to the Data Tab and select Data Analysis.

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 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

As noted above, you get the same answer of Beta **(Beta Coefficient) **in each of the methods.

Also, note that MakeMyTrip beta is approximately closer to 1.0, this implies that MakeMyTrip stock prices have the same level of risk as the broad NASDAQ Index.

You may download the fully solved Beta Calculation Worksheet from here.

**Levered vs Unlevered Beta**

**Levered Beta** is the Beta that contains the effect of capital structure i.e. Debt and Equity both. The beta that we calculated above is the Levered Beta.

**Unlevered Beta** is the Beta after removing the effects of the capital structure. As seen above, once we remove the financial leverage effect, we will be able to find the Unlevered Beta.

Unlevered Beta can be calculated using the following formula –

As an example, let us find out the **Unlevered Beta for MakeMyTrip.**

Debt to Equity Ratio (MakeMyTrip) = 0.27

Tax Rate = 30% (assumed)

Beta (levered) = 0.9859 (from above)

## Calculate Beta of an Unlisted or Private Company

As seen earlier, Beta is a statistical measure of the variability of a company’s stock price in relation to the stock market overall. However, when we evaluate private companies (not listed), then how should we find Beta? In this case, Beta does not exists, however, we can find an IMPLIED BETA from the comparable companies analysis.

Implied Beta is found using the following 3 step process –

##### Step 1 – Find all the Listed Comparables whose Beta’s are readily available.

Please note that the Betas that you download are Levered Betas and hence, it is important to remove the effect of capital structure. Higher amount of debt implies higher variablility in earnings (Financial Leverage) which in turn results in higher sensitivity to the stock prices.

Let us assume here that we want to find the Beta of private company, lets call this as PRIVATE. As a first step, we find all the listed peers and identify their Betas (levered)

##### Step 2 – Unlever the Betas

We will use the formula discussed above to Unlever the Beta.

Please note that for each of the competitors, you will have to find the additional information like Debt to Equity and Tax Rates. While unlevering, we will be able to remove the effect of financial leverage.

##### Step 3: Relever the Beta

We then relever the beta at an optimal capital structure of the PRIVATE company as defined by industry parameters or management expectations. In this case, ABC company is assumed to have the Debt/Equity of 0.25x and Tax Rate of 30%.

The calculation for the relevered beta is as follows:

It is this relevered Beta that is used for calculating the Cost of Equity of the Private companies.

## What Does a Negative Beta Mean?

Though in the above cases we saw that Beta was greater than zero, however, there may be stocks that have negative betas. Theoretically, negative beta would mean that the stock moves in the opposite direction of the overall stock market. Though, these stocks are rate, but they do exist. Many companies that are into gold investing can have negative betas because gold and stock markets move in the opposite direction. International companies may also have negative beta as their business maynot be directly linked to the domestic economy.

If you are curious to see some examples of Negative Beta Stocks, here is the process through which you can hunt for negative beta stocks.

**Step 1 –** Visit Yahoo Screener

##### Step 2 – Choose the Industry Filter

You may choose the sector/industry of your choice. I have picked up Gold (Basic Materials)

##### Step 3 – Choose the Beta Values Minimum and Maximum

##### Step 4 – Click on Find Stocks and you will see the list below

##### Step 5 – Sort the Beta column from Low to High

**Step 6 – Enjoy the list of Negative Betas 🙂**

## Advantages of CAPM Beta

- Single measure to provide an understanding of security volatility as compared to the market. This understanding of stock volatility helps the porfolio manager with his decisions of adding or deleting this security from the portfolio.
- Most of the investors have diversified portfolios from which unsystematic risk has been eliminated. Beta only considers systematic risk thereby providing the real picture of the risks involved.

## Disadvantages of CAPM Beta

**“Past Performance is no guarantee of future”**– This rule also applies on Beta. While we calculate beta, we take into account historical data – 1 year, 2 years or 5 years etc. Using this historical beta may not hold true in the future.**Cannot accurately measure Beta for new Stocks**– As we saw from above that we can calculate beta of unlisted or private companies. However, the problem lies in finding the true comparable that can provide us with an implied Beta number. Unfortunately, we do not always have the right comparable for start-ups or private companies.- Beta does not tell us whether the stock was more volatile during the bear phase or the bull phase. It does not distinguish between upswings or downswing movements.

## Interesting Valuation Articles

## What next?

If you learned something new or enjoyed the post, please leave a comment below. Let me know what you think. Many thanks and take care. Happy Learning!

Prithvi says

Very informative, thank you very much for the explanation.

Dheeraj Vaidya says

thanks Prithvi!

VENKATESH says

well explained in simple steps. very informative.

Dheeraj Vaidya says

thanks Venkatesh!

Mahmoud says

many thanks! you make it very clear

Dheeraj Vaidya says

My Pleasure Mahmoud!

Jithin says

Thank you so much for the article and the worksheet. Helped a lot to understand. Keep on writing.

Dheeraj says

thanks Jithin!

Terry says

It’s a great essay to understand the Beta. Now I get the approaches to calculate beta from stock market.

Thank you so much!

But I have a question about beta:Suppose a statement said a corp. carried $200 million debt and has 15 million shares trading at price of $30 in TSX. It’s stock beta is 0.9. This beta is levered beta or unlevered beta?Thanks!

Terry

Dheeraj says

Hi Terry,

The stock beta that is mentioned in bloomberg and other databases is levered beta (includes the effect of debt). If you want to calculated the unlevered beta from this, then you need to apply the formula to unlever the same.

Thanks,

Dheeraj

Ali says

You are soooooooooo gooood

Dheeraj says

thanks Ali!

MARIA SHUJA says

thank sir u really make it easy…

Dheeraj says

thanks Maria!

Kola Yaqub says

Thanks for sharing the wonderful knowledge. It is very informative and explanatory.

I like appreciate more education on other seemingly confusing areas in finance such as fixed income, derivatives and asset beta.

Thank you once again

Dheeraj says

Hello Kola,

Many thanks for your appreciation 🙂

Best,

Dheeraj

Gaurav verma says

Awesome brother you are doing good work. This article is very very helpful to me and many others.

Dheeraj says

thank you Gaurav!

Herman Tan says

This is great Dheeraj.

It is very clear explanation.

Dheeraj says

thank you Herman 🙂

Vitali says

great, Dheeraj

Dheeraj says

Thank you Vitali!

Berenice says

Very didatic article. Thanks and congratulations!

Dheeraj says

Thanks Berenice!

vincent says

I like the way you have explained finance concepts, its clear and enjoyable. Also thanks for sharing your knowledge and some data here 🙂

Nadine says

This is comprehensive, simple to understand and awesome! Thanks sooo much!

Huron says

Very clear explanation. Thanks!

Somsubhra Mukherjee says

Simple and very welled explained…Can you please upload module on FOREX.

Dheeraj says

Thanks Somsubhra. I am looking forward to an article on Forex in the near future.

msdevi says

well explained in a simple way.

Manohar says

You explained in very lucid and simple language . Looking forward for more posts on security valuation.

Thanks

Ankit says

Sir, request you to take some important FM concepts on a regular basis like minority interest and adjustments and other such important but often ignored concepts.

Thanks.

Ankit says

it was a great article in a way that though i learnt beta concepts during my MBA, but it was not this thorough and practical in approach. and yahoo screener was a new thing as well.

sandheep says

Your articles are always simple and interesting.

Thank you

AVGRAO says

Sir,Ur article is excellent. Without abc knowledge in FM, this articles creates LOVE in FM. With regards

AVGRAO says

excellent Sir, with regards

mahendra edunoori says

its a very important article. and i learned new things with your article. i glad to thanks to you….

Neeraj says

Your article always have new things for me to learn from

Anika Kalra says

I thought negative beta stocks are difficult to find. Your article is very comprehensive. Thanks Dheeraj

Wall Street Mojo says

Thanks Anika!