CAPM Beta

CAPM Beta is a theoretical measure of the way how a single stock moves with respect to the market, by taking correlation between the both; market represents the unsystematic risk and beta represents the systematic risk.

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 to market capitalization, revenue size, sector, growth, management, etc. Can we find a single measure that tells us which stock is riskier? 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 –

What is the CAPM Beta?

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.

CAPM Beta Formula

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

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

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: CAPM Beta (wallstreetmojo.com)

If you have not heard of Beta yet, then worry not. This article explains to you about Beta in the 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.

What is Beta?

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

Beta Values

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: CAPM Beta (wallstreetmojo.com)

In general, large companies with more predictable Financial StatementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more and profitability will have a lower beta value. For example, Energy, Utilities, and Banks, etc., all tend to have a 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 a lot of factors – usually, the nature of the business, operating and financial leverages, etc.

The below diagram shows the key determinants of Beta –

Beta Determinants

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: CAPM Beta (wallstreetmojo.com)

High Beta Stocks/Sectors

Due to the 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 economic activities. If the economy is in recession, then these stocks exhibit poor results, and thereby stock performance takes a beating. Likewise, if the economy is on a high growth trajectory, cyclical stocksCyclical StocksA cyclical stock refers to that share whose price fluctuates with the change in overall macroeconomic conditions. Such a stock is sensitive to the various economic phases like recession, boom, expansion, contraction, trough, peak and recovery.read more tend to be highly correlated and demonstrate a 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%.

The 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 the defensive sector. Defensive stocksDefensive StocksA Defensive Stock is a stock that provides steady growth and earnings to the investors in the form of dividends irrespective of the state of the economy as it has a low correlation with the overall stock market/economy and is therefore insulated from changing business cycles.read more are stocks whose business activities and stock prices are not correlated with 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%.

The 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 the Beta of MakeMyTrip (MMTY) and Market Index as NASDAQ.

Step 1 – Download the Stock Prices & Index Data for the past 3 years. 

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

NASDAQ Historical Prices Download

Likewise, download the corresponding stock price data for the 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. 
Beta Calculation - Step 2
Step 3 – Prepare a single sheet of Stock Prices Data & Index Data.
Beta Calculation - Step 3
Step 4 – Calculate the Fractional Daily Return
Beta Calculation - Step 4
Step 5 – Calculate Beta – Three Methods

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

  • Variance / Covariance Method 
Beta Calculation using Variance Covariance

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

  • SLOPE function in excel 
Beta Calculation using SLOPE Method

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.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 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.read more -> Go -> Check Analysis ToolPak -> OK

Select Data Analysis and click on Regression.Data Analysis - Regression

Choose the Y Input Range and X Input Range

Regression Range

Once you click OK, you get the following Summary Output

Regression 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 to the broad NASDAQ Index.

Levered vs. Unlevered Beta

Levered Beta or Equity 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 calculate Unlevered Beta.

Unlevered Beta can be calculated using the following formula –

       Beta (Unlevered) = Beta (levered)/ (1+ (1-tax) * (Debt/Equity))

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

Debt to Equity RatioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. read more (MakeMyTrip) = 0.27

Tax Rate = 30% (assumed)

Beta (levered) = 0.9859 (from above)

       Beta (Unlevered) = 0.9859 / (1+ (1-30) * 0.27)

       Beta (Unlevered) = 0.8291

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 we should find Beta? In this case, Beta does not exist; 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 BetasLevered BetasLevered beta measures the systematic risk of a stock that includes risk due to macroeconomic events like war, political events, recession, etc. Systematic risk is inherent to the entire market and is also known as undiversifiable risk.read more, and hence, it is important to remove the effect of capital structure. The higher amount of debt implies higher variability in earnings (Financial LeverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more), which in turn results in higher sensitivity to the stock prices.

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

Private Company Beta Competitors
Step 2 – Unlever the Betas 

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

               Beta (Unlevered) = Beta (levered)/ (1+ (1-tax) * (Debt/Equity))

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

Private Company Beta Competitors - Unlevered
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 a Debt/Equity of 0.25x and a Tax Rate of 30%.

The calculation for the relevered beta is as follows:

Relevered Beta

It is this relevered Beta that is used for calculating the Cost of EquityCalculating 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). read more 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, the negative beta would mean that the stock moves in the opposite direction of the overall stock market. Though these stocks are rate, 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 may not 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
Yahoo Screener
Step 2 – Choose the Industry Filter

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

Yahoo Screener - Gold
Step 3 – Choose the Beta Values Minimum and Maximum
Yahoo Screener - Choose Beta values
Step 4 – Click on Find Stocks, and you will see the list below
Gold Beta List
Step 5 – Sort the Beta column from Low to High
Negative Beta List

Step 6 – Enjoy the list of Negative Betas :-)

Advantages of CAPM Beta

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.

CAPM Beta Video

  1. Beta Formula
  2. Stock Beta Meaning
  3. Sum of Parts Valuation

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!

Reader Interactions

Comments

  1. Silky Kushwah says

    quite interesting!

    Enjoyed reading..

    Thanks

    • Dheeraj Vaidya says

      Thanks for your kind words!

  2. Thuy says

    This is the most amazing blog I have ever seen. Thank you so much for your sharing since your sharing is so informative and is written in the order that really easy to follow.

    • Dheeraj Vaidya says

      Thanks for your kind words!

  3. vero says

    I LOVE YOUR ARTICLES VERY KNOWLEDGEABLE AND INFORMATIVE

  4. Kenei says

    You are a rockstar! Thanks for sharing.

  5. Prithvi says

    Very informative, thank you very much for the explanation.

    • Dheeraj Vaidya says

      thanks Prithvi!

  6. VENKATESH says

    well explained in simple steps. very informative.

  7. Mahmoud says

    many thanks! you make it very clear

    • Dheeraj Vaidya says

      My Pleasure Mahmoud!

  8. Jithin says

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

    • Dheeraj says

      thanks Jithin!

  9. 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

  10. Ali says

    You are soooooooooo gooood

    • Dheeraj says

      thanks Ali!

  11. MARIA SHUJA says

    thank sir u really make it easy…

    • Dheeraj says

      thanks Maria!

  12. 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

  13. 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!

  14. Herman Tan says

    This is great Dheeraj.
    It is very clear explanation.

    • Dheeraj says

      thank you Herman :-)

  15. Vitali says

    great, Dheeraj

    • Dheeraj says

      Thank you Vitali!

  16. Berenice says

    Very didatic article. Thanks and congratulations!

    • Dheeraj says

      Thanks Berenice!

  17. 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 :)

  18. Nadine says

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

  19. Huron says

    Very clear explanation. Thanks!

  20. 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.

  21. msdevi says

    well explained in a simple way.

  22. Manohar says

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

  23. 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.

  24. 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.

  25. sandheep says

    Your articles are always simple and interesting.
    Thank you

  26. 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

  27. mahendra edunoori says

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

  28. Neeraj says

    Your article always have new things for me to learn from

  29. 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!

Leave a Reply

Your email address will not be published. Required fields are marked *