A beta coefficient is a measure of the volatility, or systematic risk, of an individual stock in comparison to the unsystematic risk of the entire market. In other words, beta helps us understand how stock returns react to market fluctuations. The more it gets changed/ affected/ fluctuated, the higher will be the beta and vice versa. Basically beta helps the investors determine how risky the stock is w.r.t the market movements.
There are multiple types of beta valuations; they’re used for different purposes such as equity beta, asset beta, levered beta, etc. Asset beta considers business risk but not leverage risk. Unlevered beta considers both business and leverage risk (debt risk). Equity Beta is used under CAPM (capital asset pricing model) valuation principle and we’ll have a look at how the formula is used:-
Beta coefficient (β) = Covariance (Re, Rm)
Re = return on individual stock
Rm = return on the overall market
β = beta
Covariance = how changes in stock’s returns are related to changes in market returns
Variance = how far the markets data point spread out from their average value
Although the CAPM model is widely used by multiple fund managers, it has one drawback to it which is the overall market condition/performance.
So the market itself becomes the benchmark in determining the beta of security. R-squared is a relationship made to the beta of a stock. It helps in confirming if the stock is getting compared to the correct benchmark. Beta value is usually set at 1 being balanced, below 1 being a low beta or safer stock, and vice versa. A similar case can be found out for R-squared of a stock. Higher the R-squared value, better it is w.r.t. being compared to the correct benchmark. Some stocks have beta value is negative that means the stock goes in the opposite direction to the market value. Beta is used by investors, fund managers, etc. to help determine the riskiness of stock, thereby concluding and building a well-diversified portfolio. Beta is not only used for stocks but also for bonds, debentures, mutual funds, etc.
Here is a simplified format of understanding of the beta:-
- β = 1 exactly as volatile as the market
- β > 1 more volatile than the market
- β < 1 > 0 less volatile than the market
- β = 0 uncorrelated to the market
- β < 0 negatively correlated to the market
Further, here are a few more relationships of the R-squared beta:-
- R squared β = 1 the comparison to the benchmark is neutral
- R squared β> 1 the comparison to the benchmark is not correct and therefore should be taken into consideration
- R squared β< 1 > 0 the comparison to the benchmark is apt and gets better as it gets higher
- R squared β = 0 OR < 0 the comparison is not made properly to its benchmark.
Considering an example if a company has a beta of 1.6 it means that the returns of the company are 160% more volatile to the market.
High beta v/s low beta
As discussed above high and low beta, it justifies the riskiness of stock plus a very low beta (negative beta) or a very high beta can be detrimental for the investors. Although it is a risk managing valuation and it may not be completely vital in order to understand a stock.
Consider an example-
If a company is in a downtrend for a few months and the beta is very high then it may be able to have a positive impact but most probably not. Looking at the other picture if the beta is low then it will not be even able to make profits in the bull market either thereby justifying that beta cannot be solely considered. Let it be high or low. Furthermore, beta is calculated by the historical movements displayed by the stock, therefore, it cannot be used for future valuations. So even if the value is high or low it may get of less use to experienced investors.
To conclude, an investor should be careful while analyzing the Beta of any stock as it may have negative impacts if not studied properly.