What is Equity Beta?
Equity Beta measures the volatility of the stock to the market, i.e., how sensitive is the stock price to a change in the overall market. It compares the volatility associated with the change in prices of a security. Equity Beta is commonly referred to as levered beta, i.e., a betaBetaBeta is a financial metric that determines how sensitive a stock's price is to changes in the market price (index). It's used to analyze the systematic risks associated with a specific investment. In statistics, beta is the slope of a line that can be calculated by regressing stock returns against market returns. of the firm, which has 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. .
- It is different from the asset beta of the firm as the same changes with the capital structure of the company, which includes the debt portion. Asset beta is also known as unlevered beta” and is the beta of the firm which has zero debt.
- If the firm has zero debt, the asset beta and equity beta are the same. As the debt burden of the company increases, equity beta increases.
- Equity beta is one of the major components of the CAPM model for evaluating the expected return of the stockExpected Return Of The StockThe Expected Return formula is determined by applying all the Investments portfolio weights with their respective returns and doing the total of results. Expected return = (p1 * r1) + (p2 * r2) + ………… + (pn * rn), where, pi = Probability of each return and ri = Rate of return with probability. .
Interpretations of Equity Beta
Below mentioned are some of the scenarios in which beta can be interpreted in order to analyze the company’s performance as compared to its peers and the sensitivity analysisSensitivity AnalysisSensitivity analysis is a type of analysis that is based on what-if analysis, which examines how independent factors influence the dependent aspect and predicts the outcome when an analysis is performed under certain conditions. of the same with reference to the benchmark index used in its calculation.
- Beta < 0 – The underlying asset moves in the opposite direction to a change in the benchmark index. Example: an inverse exchange-traded fund
- Beta = 0 – The movement of the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. is not correlated to the movement of the benchmark. example: fixed yield assets like government bonds, treasury bills, etc
- 0<Beta<1 – The movement of the underlying asset is in the same direction but less than the benchmark. example: stable stocks like FMCG industries or consumer goods
- Beta =1 -The movement of the underlying asset exactly matches the benchmark index. It is a representative stock of the benchmark index showing correct returns as compared to the market volatility.
- Beta >1 – The movement of the underlying asset is in the same direction but more than the movement in the benchmark index. Example: such stocks are very much influences with the day to day market news and swing very fast due to heavy trading happening in the stock, which makes it volatile and attractive to traders.
Equity Beta Formula
Below are the formulas for Equity Beta.
Equity Beta Formula = Asset Beta ( 1 + D/E( 1-Tax )
Equity Beta Formula = Covariance ( Rs,Rm) / Variance (Rm)
- Rs is the return on a stock,
- Rm is a return on market and cov (rs, rm) is 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 covariance.
- Return on stock = risk-free rate + equity beta (market rate – risk-free rate)
Top 3 Methods to Calculate Equity Beta
Equity beta can be calculated in the following three methods.
Method #1 – Using the CAPM Model
An asset is expected to generate at least the risk-free rate of returnRisk-free Rate Of ReturnA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk. from the market. If the beta of the stock equals to 1, this means the returns are with a par of the average market returns.
Steps to calculate Equity Beta using the CAPM Model:
Step 1: Find out the risk-free return. It is the rate of return where the investor’s money is not at Risk-like treasury billsTreasury BillsTreasury Bills or a T-Bill controls temporary liquidity fluctuations. The Central Bank is responsible for issuing the same on behalf of the government. It is given at its redemption price and a discounted rate and is repaid when it reaches maturity. or the government bonds. Let’s assume its 2%
Step 2: Determine the expected rate of return for the stock and the market/index to be considered.
Step 3: Input the above numbers in the CAPM Model, as mentioned above, to derive at the beta of the stock.
We have the following data as: exp rate of return = 7% , market rate of return = 8% & risk free rate of return = 2%. calculate beta using the CAPM model.
- Exp Rate of Return: 7%
- Market Rate of Return: 8%
- Risk Free Rate of Return: 2%
As per CAPM Model, exp rate of return on stock = risk-free rate + beta (market rate – risk-free rate)
Therefore, beta = (exp rate of return on stock – risk-free rate)/(market rate–risk-free rate)
So, the calculation of beta is as follows –
Hence Beta = (7%-2%)/ (8%-2%) = 0.833
Method #2 – Using Slope Tool
Let’s calculate the equity beta of Infosys stock using the slope.
Steps to calculate Equity Beta using Slope –
Step 1: Download the historical data for Infosys from the stock exchangeStock ExchangeStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ. website for the past 365 days and plot the same in an excel sheet in column b with dates mentioned in column a.
Step 2: Download the nifty 50 index data from the stock exchange website and plot the same in next column c
Step 3: Take only the closing prices for both the data as above
Step 4: Calculate the daily returns in % for Infosys and nifty both till the last day in column d and column e
Step 5: Apply the formula: =slope (d2:d365,e2:e365) to get the beta value.
Calculate beta by regression and slope tool both using the below-mentioned table.
|Date||Stock Price||Nifty||% change in Stock Price||% change in Nifty|
Beta by regression method –
- Beta = COVAR(D2:D6,E2:E6)/VAR(E2:E6)
By Slope Method –
- Beta = Slope(D2:D6, E2:E6)
Method #3 – Using Unlevered Beta
Equity Beta is also known as a levered beta since it determines the level of firms debt to equity. It’s a financial calculation that indicates the systematic risk of a stockSystematic Risk Of A StockSystematic 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”. used in the CAPM model.
Mr. A analyses a stock whose unlevered beta is 1.5, debt-equity ratioDebt-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. of 4%, and a tax rate =30%. Calculate the levered beta.
- Beta: 1.5
- Debt-Equity Ratio: 4%
- Tax Rate: 30%
Calculation of levered beta is as follows –
- Levered Beta Formula= Unlevered Beta ( 1+ (1-Tax)*D/E Ratio)
- = 1.5(1+(1-0.30)*4%
- = 1.542
Hence the equity beta of the company is a measure of how sensitive is the stock price to changes in the market as well as the macroeconomic factors in the industry. It’s a number describing how the return of an asset is predicted by a benchmark set compared against it.
- It helps us to analyze in a broad way how the stock returns can deviate due to changes in the micro & macro environment.Macro Environment.Macro environment refers to the condition that impacts the whole economy instead of a single industry or sector. It comprises inflation, monetary or fiscal policy reforms, employment rates, gross domestic product (GDP) trends, and shift in consumer spending.
- It has some criticism as well since the past performance of the company does not predict future performance, and therefore beta is not the only measure of risk. However, it can be used as a component while analyzing the company’s business performance and future strategical plans & policies that will impact the growth prospects of the same.
This article has been a guide to Equity Beta. Here we discuss what is Equity Beta, its formula, and how to calculate equity beta along with the practical examples. You can learn more about financing from the following articles –