The beta (β) of a stock is there to give the volatility or systematic risk of returns relative to the entire market. It is viewed as a risk measurement and is an integral part of the Capital Asset Pricing Model (CAPM). Overall, a beta above 1 indicates higher volatility exposure of the market, whereas a lower than 1 indicates low volatility from the entire market. In other words, a stock’s beta is an indicator for investors to understand if the company’s stock price moves along or is correlated to the market volatility.
Capital Asset Pricing Model (CAPM) is widely used as a method of calculating the expected return of assets considering the systematic risk and the cost of capital of these assets.
Systematic risk is also known as the not diversifiable risk, whereas unsystematic risk is a diversifiable risk. This means that a not diversifiable risk-systematic risk cannot be avoided since it is already inherent in the market. On the contrary, unsystematic risk can be diversified by investors. This is why the beta is important to consider since it is not in investors’ hands to diversify but instead willing to take it.
This is a way of investors splitting the two risks into two categories. For instance, the surprisingly financial crisis that appeared during 2008 is an example of a systematic risk event with no amount of diversification possible. No investor could prevent this from happening or affecting them. Therefore, it is known as a non-diversifiable risk.
The unsystematic risk can be given by the example of the company Boeing aircraft. The fact that three of their airplanes crashed in less than one and a half years is something that will affect the specific company only and does not mean any risk for similar companies. Therefore, this stock can be diversifiable if they come up with better regulations to prevent these crashes and provide safer and trustworthy planes.
β =1 exactly as volatile as the market
β>1 more volatile than the market
β<1 less volatile than the market
β=0 uncorrelated to the market
β<0 negatively correlated to the market.
High β – A company with a high β needs to be greater than 1 which means it is more volatile than the market. For example, a high-risk technology company that has a beta of 1.85 would have returned 185% of what the market returned in a given period (typically measured weekly).
Low β – A company with a low β needs to be less than 1 which means it is less volatile than the market. For example, an energy company with a beta of 0.67 could have returned only 67% of what the market would return in a given period of time.
Negative β – A company with a negative β means that is negatively correlated to the returns of the market. For example, a gold company with a beta of -0.04 could have returned -4%when the market was up 10% and vice versa.
Beta coefficient (β) = (Covariance (Re,Rm)) / (Variance (Rm) )
Re = the return on an individual stock
Rm = the return on the overall market
Covariance = how changes in a stock’s returns are related to changes in the market’s returns
Variance = how far the market’s data points spread out from their average value
A beta coefficient can measure the volatility of an individual stock against the systematic risk of the entire market. It shows the slope of the line that passes through a regression of data points.
It effectively describes the activity of a security’s returns as it responds to the fluctuation that is happening in the market. The beta is calculated by dividing (covariance) the stock’s returns and the returns of the overall market by the market data points spread-out from their average value(variance).
The beta calculation is here to help investors to understand whether a stock is moving along in the same direction as the market and to what extend. Additionally, it provides insights about how volatile or in other words how risky the stock is relative to the rest of the market. For it to provide any useful insights the market is used as the benchmark and should be related to the stock. For instance, calculating a bond ETF using the S&P 500 as the benchmark would not provide much helpful insight for an investor because bonds and stocks are not in any way similar and in fact are very dissimilar.
Basically, an investor will use the beta to understand how much risk a stock is adding to his portfolio. A stock that deviates from the market would not add a lot of risk to the portfolio, but it will not also increase the returns.
The tip to making sure that the right stock has been compared to the right benchmark – it should have an R-squared value in relation to the benchmark. I know that now you are thinking about what this is again. But I promise this is not something difficult to understand. In simple words, R-square is a statistical measure that shows the percentage of a security’s historical price movements that can be explained by movements in the benchmark being used.
Levered beta, also known as equity beta or stock beta takes into consideration the volatility of returns for a stock with the impact of the company’s leverage from its capital structure. The result from this is the comparison of both the volatility also referred to as the risk of a levered company to the risk of the overall market.
The levered one includes both the business risk and debt risk. The reason it is also known as the equity beta is because it is the volatility of the company’s equity-based on its capital structure. The formula is the following:
Levered Beta = Unlevered Beta * ((1 + (1 – Tax Rate) * (Debt / Equity))
Asset or unleveled beta is different and does not consider two factors. In fact, it is only showing the risk of an unlevered company relative to the overall market. In other words, it includes the business risk but does not include the leverage risk. The formula of the levered beta is the following:
Unlevered β = Levered β / ((1 + (1 – Tax Rate) * (Debt / Equity))
Equity beta allows investors to assess the security’s sensitivity to the overall market risks. For example, if a company has a beta of 1.5 it denotes returns that are 150% as volatile as the market returns are being compared to.
The higher the debt or leverage of a company the greater the risk. This is due to the adding uncertainty of the future earnings of the company. In some situations, it is better to remove the company’s debt or financial leverage since the unlevered beta can capture the risk of the company’s assets only.
From what we have already understood it can be very useful to investors when evaluation a stock. However, as in every story, beta also has limitations. It is very useful when it comes to a stock’s short-term risk and for analyzing volatility to arrive at equity costs when using the CAPM. Beta is calculated on historical data or past price movements which is why it becomes less reliable when we are looking to predict a stock’s future movement.
Moreover, beta can be less useful to investors that are long-term. This is because a stock’s volatility can be shifted dramatically from year to year, and this depends on the company’s performance and the growth potential along with other factors.