What is Stock Beta?
Stock Beta is one of the statistical tools that quantify the volatility in the prices of a security or stock with reference to the market as a whole or any other benchmark used for comparing the performance of the security. It is actually a component of Capital Asset Pricing Model (CAPM) which is used to calculate the expected returns of an asset based on the underlying Beta, risk-free rate and the risk premium.
Stock Beta formula
Stock’s Beta is calculated as the division of covariance of the stock’s returns and the benchmark’s returns by the variance of the benchmark’s returns over a predefined period.
Below is the formula to calculate stock Beta.
Stock Beta Formula = COV(Rs,RM) / VAR(Rm)
Here,
- Rs refers to the returns of the stock
- Rm refers to the returns of the market as a whole or the underlying benchmark used for comparison
- Cov(Rs, Rm) refers to the covariance of the stock and market
- Var(Rm) refers to the Variance of market
If we focus on the components that go into the calculation of Stock Beta, it would become much more evident that:
- It helps in assessing the direction of movement of the stock with reference to the direction of the movement of the market or the benchmark used for the comparison.
- How sensitive or volatile is the stock’s price movement with respect to the market or the benchmark?
One more important thing that is worth mentioning is that there should be some kind of relation between stock and the market or the benchmark used for the comparison as otherwise, the analysis would serve no purpose. For example, an oil company stock and an index weighted majorly by technology companies would not have much of a relationship as the businesses are too dissimilar to compare, and hence no practically useful insight may come out of the Beta calculation between the two.
Calculate Stock Beta of MakeMyTrip
Let us calculate the Stock Beta of a NASDAQ Listed company MakeMyTrip (MMTY).
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The benchmark index is NASDAQ.
Steps to Calculate Stock Beta are as follows
Step 1 – Download the stock prices and NASDAQ index prices for the past couple of years.
For NASDAQ, download the dataset from Yahoo Finance.
Likewise, download the corresponding stock price data for the MakeMyTrip example from here.
Step 2 – Sort the data in the requisite format.
Please format the data as per the details provided below.
Step 3 – Prepare an excel sheet with stock price data and NASDAQ data.
Step 4 – Calculate the percentage change in Stock Prices and NASDAQ.
Step 5 – Calculate Stock Beta using the Variance/Covariance Formula.
Using the variance-covariance stock beta formula, we get the Beta as 0.9859 (Beta Coefficient)
What Does Stock Beta Imply?
It may look like an overly mathematical formula, but it does provide both qualitative and quantitative actionable information. The sign (positive or negative) indicates the direction of the movement of the stock in question with respect to that of the underlying market or benchmark against which the stock’s movement is assessed.
The Stock Beta can have three types of values:
- Beta < 0: If the Beta is negative, then this implies an inverse relationship between the stock and the underlying market or the benchmark in comparison. Both stock and the market or the benchmark will move in the opposite direction.
- Beta = 0: If the Beta is equal to zero, then this implies that there is no relation between the movement of the returns of the stock and the market or the benchmark, and hence both are too dissimilar to have any common pattern in price movements.
- Beta > 0: If the Beta is greater than zero, then there is a strong direct relationship between the stock and the underlying market or the benchmark. Both stock and the market or the benchmark will move in the same direction. Some further insight is as follows:
- Beta between 0 and 1 implies that the stock is less volatile than the underlying market of the benchmark.
- Beta of 1 implies that the volatility of the stock is exactly the same as that of the underlying market or the index in both qualitative and quantitative terms.
- Beta of greater than 1 implies that the stock is more volatile than the underlying market or index.
A negative Beta is possible but highly unlikely. Most investors believe that gold and stock based on gold tend to perform better when the market dives. Whereas a Beta of zero is possible in the case of government bonds acting as risk-free securities providing a low yield to the investors. And a Beta of greater than zero is the most common scenario that we see in the investment world. Most of the stocks follow this pattern.
Conclusion
It is one single statistical tool that investors frequently use to assess the risk that the stock may add to their portfolio, allowing them to gauge the risk in both qualitative and quantitative terms and to assess the risk and rewards associated with the stock. Using their analysis of Beta and their market acumen, the investors can take action regarding the stock.
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