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 Perhaps the single most important measure of stock risk or volatility is a stock's beta. It's one of those at-a-glance measures that can provide serious stock analysts with insights into the movements of a particular stock relative to market movements.
In this article we're going to first attempt to define the concept of beta values including some of the theory upon which it's based. Next we're going to talk about the pros and cons of the measure while hopefully providing insights into the correct use of beta values when analyzing a stock. Finally, we're going to finish up with a practical explanation of how to calculate beta as well as a link to a spreadsheet you can use to calculate these values yourself.
Beta Values
The concept of beta is actually very simple - it's a measure of individual stock risk relative to the overall stock market risk. It's sometimes referred to as financial elasticity. It's just one of several values that stock analysts use to get a better feel for a stock's risk profile. As we'll see later on in our discussion, the beta value is calculated using price movements of the stock we're analyzing and comparing those movements to an overall market indicator - such as a market index - over the same period of time.
Beta Rules of Thumb
Beta values are fairly easy to interpret. If the stock's price experiences movements that are greater - more volatile - than the stock market, then the beta value will be greater than 1. If a stock's price movements, or swings, are less than those of the market then the beta value will be less than 1.
Since increased volatility of stock price means more risk to the investor, we'd also expect greater returns from stocks with betas over 1. The reverse is true of a stock's beta is less than 1 - we'd expect less volatility, lower risk, and therefore lower overall returns.
CAPM Theory and Beta
During our discussions of calculating stock prices and our follow up discussion of the capital asset pricing model, or CAPM, we explained how we could calculate the expected return on an investment by examining risk-free investments, expectations of the stock market, and stock betas.
For example, by using the following CAPM formula we can calculate the expected rate of return on an investment as:
Expected Rate of Return = r = rf + ß (rm - rf)
Where:
- rf = The risk-free interest rate is the interest rate the investor would expect to receive from a risk-free investment. Typically, US Treasury Bills are used for US dollars and German Government bills are used for the Euro.
- ß = A stock beta is used to mathematically describe the relationship between the movements of an individual stock versus the market itself. Investors can use a stock's beta to measure the risk of a security versus the market.
- rm = The expected market return is the return the investor would expect to receive from a broad stock market indicator such as the S&P 500. For example, over the last 17 years or so, the S&P 500 has yielded investors an average annual return of around 8.10%.
If we were to translate this CAPM formula into words we'd say the following:
"The expected return on an investment is equal to the return on a risk-free investment plus the risk premium that's associated with the stock market itself adjusted for the relative risk of the common stock we've chosen."
Stock beta values are a key element when using the CAPM. If you'd like to work through some examples to see how this theory works in practice then try our online CAPM calculator.
Advantages and Disadvantages of Beta
In the next two sections we're going to discuss the advantages and disadvantages of beta values. The outcome of this discussion should be an overall understanding of how to use this measure in practice. For example, you might want to look at a stock's beta before making a purchase decision. That's a good step to take in your stock research - as long as you understand what the value is telling you.
Advantages of Beta
The calculation of beta is based on extremely sound finance theory. The CAPM pricing theory is about as good as it gets when it comes to pricing stocks and is far easier to put into practice when compared to the Arbitrage Pricing Theory or APT. If you're thinking about investing in a company's stock, then the beta allows you to understand if the price of that security has been more or less volatile than the market itself - and that's certainly a good thing to understand about a stock you're planning to add to your portfolio.
If we understand the theory behind beta, then it's easy to understand how emerging tech stocks typically have beta values greater than 1, while 100 year-old utility stocks typically have beta values less than 1. In fact, in March 2007 Priceline.com had a beta of 3.4 while Public Service Enterprise Group had a beta of 0.57. It's nice when theory seems to work in the real world.
Disadvantages of Beta
We're a big advocate of value investing and conducting stock research that focuses on a company's fundamentals and an understanding of financial ratios before investing in a stock. Unfortunately if you're calculating stock beta values using price movements over the past three years, then you need to bear in mind that the "past performance is no guarantee of future returns" rule applies to beta.
Beta is calculated based on historical price movements - which may have little to do with how a company's stock is poised to move in the future. And because the measure relies on historical prices it's not even possible to accurately calculate the beta of newly issued stocks.
Beta also doesn't tell us if the stock's movements were more volatile during bear markets or bull markets - it doesn't distinguish between large upswing or downside movements. So while beta can tell us something about the past risk of a security, it tells us very little about the attractiveness or the value of the investment today.
Beta Calculations
You'll find calculated values of beta on all of the major stock reporting websites - Yahoo Finance, MSN Money, and Google Finance all report stock beta values. You can also calculate beta yourself using a fairly straightforward linear regression technique that's available in a spreadsheet application such as Microsoft's Excel or OpenOffice Calc.
In fact, to calculate a stock's beta you only need two sets of data:
- Closing stock prices for the stock you're examining.
- Closing prices for the index you're choosing as a proxy for the stock market.
Most of the time beta values are calculated using the month-end stock price for the security you're examining and the month end closing price of the S&P 500 Index ($INX).
The formula for the beta can be written as:
Beta = Covariance (stock versus market returns) / Variance of the Stock Market
You can see the calculation of beta at work in our Stock Beta Calculation Spreadsheet. There you'll find not only a table that you can use to calculate the value of beta yourself, but also two charts - one for the market index and a second called the Security Characteristic Line (SCL) which applies to the stock you're analyzing.
Alpha Values
Finally, in our spreadsheet we've also included a calculation of alpha values. Alpha is a measure of excess returns on an investment which has been adjusted for risk. It's commonly used to assess the performance of a portfolio manager (such as the case with a mutual fund) as it's an indicator of their ability to provide returns in excess of a benchmark such as the S&P 500.
For example:
- If alpha < risk free investment return, then the fund manager has destroyed value;
- If alpha = risk free investment return, then the fund manager has neither created or destroyed value; and
- If alpha > risk free investment return, then the fund manager has created value.
About the Author - Stock Beta and Volatility
Copyright © 2007 Money-Zine.com
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