What is Beta

Meaning of Beta

According to finance, the beta factor measures how sensitive the stock price is to changes in its underlying market (index). In order to assess the systematic risks associated with a specific investment, the Beta factor is calculated. In statistics, beta is the slope of a line, which can be calculated by regressing the returns of a stock against the returns of the stock market (or vice versa).

Beta is primarily used in the calculation of the CAPM (Capital Asset Pricing Model). According to this model, the expected return on an asset is calculated using expected market returns and beta. The CAPM is primarily employed in the calculation of the cost of equity. When using the DCF valuation method, these factors are extremely important.

Formula

Re = the return on an individual stock

Rm =the return on the overall market

Covariance=The relationship between changes in the returns of a stock and changes in the returns of the market

Variance=a measure of how far out from the average value of the market's data points are

Interpretation of Beta

Beta = 1: Security are just as risky as the market (no market sensitivity)

Beta > 1: Security are riskier than the market (high market sensitivity)

Beta < 1: Security are less risky than the market (low market sensitivity)

Beta = 0: Security have no correlation to the market (no market sensitivity)

Example of Beta

High β - A company with a beta greater than one is more volatile than the market as a result of its earnings. Using the above example, a high-risk technology company with an alpha of 1.50 would have returned 150 percent of what the market returned over a given period of time.

Low β - It is less volatile than the entire market if a company's beta is lower than 1. Consider the case of an electric utility company with a beta of 0.30, which would have returned only 30% of what the market would have returned over a given time period as an example.

Negative β - A company with a negative beta is inversely related to the returns of the stock market in general. Consider the case of a gold company with a beta of -0.5, which would have returned -5 percent when the market was up 10%.

Understanding The Systematic and Unsystematic Risk

Systematic Risk

Rather than affecting a single company, systemic risk is inherent in the market for public equities (e.g. global pandemic, recessions)

In contrast to unsystematic risk, which can be mitigated through portfolio diversification, market risk cannot be mitigated through portfolio diversification.

Systematic risk, on the other hand, is a market risk that cannot be mitigated through diversification.

As a result, the market will demand higher potential returns as well as greater compensation for the assumption of systematic risk (which increases the cost of equity).

For the purposes of this definition, systematic risk refers to external factors that are out of the control of a specific company or organization.

Almost all securities, though some are more vulnerable than others, are exposed to systematic risk, also known as "non-diversifiable" risk because it cannot be mitigated by increasing the number of securities held in a portfolio.

Unsystematic Risk

The term "company-specific risk" (also referred to as "industry-specific risk") refers to the fact that unsystematic risk can be reduced through effective portfolio diversification. Supply chain issues and legal settlements that have an impact on a single company are two examples of such risks. The capital asset pricing model does not take into account unsystematic risk because it is company-specific and can be mitigated through diversification, particularly if the portfolio contains investments in a diverse range of industries with a diverse range of characteristics (CAPM).

Levered Beta

Leveraged beta, also known as "equity beta," is the beta of a company that takes into account the effects of the firm's capitalization structure. Generally speaking, a higher debt-to-equity ratio should result in an increase in the risk associated with a company's equity shares – provided that all other factors remain constant. The greater the amount of debt a company has (and the higher the debt-to-equity ratio), the greater the likelihood that the company will default (and the equity holders possibly getting left with nothing).

If you want to know how to calculate levered beta, the formula is as follows: multiply the unlevered beta by 1, then add the product of (1 – tax rate) and the company's debt/equity ratio.

Levered Beta = Unlevered Beta X [1 + (1 - Tax Rate) X (Debt / Equity)]

Unlevered Beta

Beta that has not been affected by financial leverage is referred to as unlevered beta. It is used to isolate the risk associated with a company's assets. Due to the fact that unlevered beta represents pure business risk, it should not be weighted to include financial risk. As a result, unlevered beta (also known as "asset beta") is frequently referred to as "asset beta" because it measures the expected volatility of a security (and its underlying company) as if the security's capital structure consisted entirely of equity financing.

In contrast to the unlevered beta of a company, the levered beta of a company changes in positive correlation with the amount of debt a company has in its financial structure. For the purposes of calculating unlevered beta, you can essentially assume that the company is financed entirely by equity, with no debt financing, and that all free cash flows (FCFs) are owned by the equity shareholders (s).

You can better understand the actual contribution of a company's equity to its risk profile when you remove the debt component from the levered beta calculation.

Using the formula, the unlevered beta is calculated by dividing the levered beta by [1 plus the product of (1 minus the tax rate) and the company's debt/equity ratio] and then multiplying the result by 1.

Unlevered Beta = Levered Beta / [1 + (1 - Tax Rate) X (Debt / Equity)]

Criticism of Beta

Numerous practitioners have voiced their opposition to the use of beta as a proxy for risk, believing it to be an inherently flawed measure of risk.

When estimating beta, the standard procedure is to use a regression model that compares historical stock returns to market benchmark returns (such as the S&;P 500, NIFTY 50, FTSE 100, etc. ) over a specified time period, with the slope of the regression line representing the beta.

Due to the fact that past performance is not always an accurate predictor of future performance, the "backward-looking" aspect of the beta calculation is one of the most significant disadvantages.

Furthermore, the capital structure (debt/equity ratio) of companies, which is a key predictor of volatility (and market performance), changes over time as companies mature and new developments in their respective industries arise.

A company's business risk over the time period covered by the regression model is represented by beta, which may be misleading if the company has undergone significant changes in terms of its business model, target customer, or other aspects of its operations.

Final point: beta is typically calculated based on the historical average financial leverage (i.e., capital structure) over the regression period, rather than the current debt-to-equity composition of the portfolio.

However, despite widespread criticism, the use of beta in academia and the workplace has persisted, owing in large part to the lack of a more suitable alternative.

Pros and Cons of Beta

Pros

Valuation: A beta is most commonly used in valuations to calculate the cost of equity, which is the most common application of a beta. The CAPM calculates the systematic risk of the market through the use of beta. A lot of different companies with a variety of capital structures can be valued using this method in general.

Volatility: In the case of stocks, beta is a single measure that allows investors to understand how volatile a stock is in comparison to the overall market. It assists portfolio managers in evaluating their decisions regarding the addition or deletion of securities from their portfolios.

Systematic Risk: Beta is a measure of the degree to which a risk is systematic. The majority of the portfolios have had unsystematic risk removed from them as a result. Beta only takes into account systematic risk, and as a result, it provides a true picture of the portfolio.

Cons

Beta can be used to help determine the likelihood of a systematic risk occurring. However, there is no assurance that future returns will be achieved. Beta can be calculated at a variety of intervals, including every two months, every six months, every five years, and so on. The data from the past cannot be used to predict the future. It makes it more difficult for the user to predict the stock's future movements in the short term.

Using stock prices in comparison to the market prices, beta is calculated for a given security. In order to avoid this, it is difficult to calculate beta for startups or private companies. There are methods such as unlevered betas and levered betas, but these also necessitate a large number of assumptions to be established.

Furthermore, beta cannot distinguish between an upswing and a downswing, which is an undesirable characteristic. It does not provide any information about when the stock was more volatile.