Equity Beta

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.read more 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. read more.

Equity Beta

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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.read more of the same with reference to the benchmark index used in its calculation.

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)

where

Top 3 Methods to Calculate Equity Beta

Equity beta can be calculated in the following three methods.

Calculate Equity Beta - Methods

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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.read more 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.read more 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.

Example

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%

Solution:

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 –

equity beta example 1.2

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.read more 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.

Example 

Calculate beta by regression and slope tool both using the below-mentioned table.

DateStock PriceNifty% change in Stock Price% change in Nifty
27-May-19708.111,924.75-0.16%0.68%
24-May-19709.211,844.001.16%1.60%
23-May-19701.05 11,657.00-1.23%-0.68%
22-May-19709.7511,737.000.06%0.24%
21-May-19709.311,709.001.33%0.08%

Beta by regression method –

example 2.2
  • Beta = COVAR(D2:D6,E2:E6)/VAR(E2:E6)
  • =0.64

By Slope Method –

example 2.3
  • Beta = Slope(D2:D6, E2:E6)
  • =0.80

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”.read more used in the CAPM model.

Example

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. read more of 4%, and a tax rate =30%. Calculate the levered beta.

  • Beta: 1.5
  • Debt-Equity Ratio: 4%
  • Tax Rate: 30%

Solution:

Calculation of levered beta is as follows –

example 3.2
  • Levered Beta Formula= Unlevered Beta ( 1+ (1-Tax)*D/E Ratio)
  • = 1.5(1+(1-0.30)*4%
  • = 1.542

Conclusion

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.

Recommended Articles

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 –

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