What is Beta in Finance?

The beta in finance is a financial metric that measures how sensitive is the stock price concerning the change in the market price (index). The Beta is used for measuring the systematic risks associated with the specific investment. In statistics, beta is the slope of the line, which is obtained by regressing the returns of stock return with that of the market return.

Beta is mainly used in calculating CAPM (Capital Asset PricingCapital Asset PricingThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more Model). This model calculates the expected return on an asset using expected market returns and beta. CAPM is mainly used in calculating the cost of equity. These measures are very important in the valuation method of DCFDCFDiscounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company’s future performance.read more.

Beta in Finance Formula

The CAPM formula uses Beta as per the below formula –

Cost of Equity = Risk-Free Rate + Beta x Risk Premium

  • Risk-free ratesRisk-free RatesA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more are usually government bonds. For example, 10-year government bonds are used at risk-free rates in the UK and US. This return is what an investor expects to gain by investing in a completely risk-free investment.Beta is the degree to which the company’s equity returns vary compared to the overall market.Risk Premium is given to the investor for taking on additional risk by investing in that stock. Since the risk from investing in the risk-free bond is much less than the equities, investors expect a higher return to take on higher risk.

Beta in Finance Interpretation

  • If Beta = 1: If the stock’s Beta was equal to one, the stock has the same risk level as the stock market. If the market rises by 1%, the stock will also rise by 1%, and if the market comes down by 1%, the stock will also come down by 1%.If Beta > 1: If the Beta of the stock is greater than one, then it implies a higher level of risk and volatility than the stock market. Though the stock price change will be the same; however, the stock price movements will be rather extreme.If Beta >0 and Beta<1: If the stock’s Beta is less than one and greater than zero, it implies the stock prices will move with the overall market; however, the stock prices will remain less risky and volatile.

Calculation of Beta in Finance

#1-Variance-Covariance Method

The beta of a security is calculated as the covarianceCovarianceCovariance is a statistical measure used to find the relationship between two assets and is calculated as the standard deviation of the return of the two assets multiplied by its correlation. If it gives a positive number then the assets are said to have positive covariance i.e. when the returns of one asset goes up, the return of second assets also goes up and vice versa for negative covariance.read more between the return of the market and the return on security divided by the variance of the market.

Beta = Covariance of the Market and the Security/ Variance of the Security

Let’s assume a portfolio manager wants to calculate beta for Apple incorporation and wants to include it in its portfolio. He decides to calculate it against its benchmark, the S&P 500. Based on the past year’s data, Apple incorporation and S&P have a covariance of 0.032, and the variance of S&P is 0.015

#2-Standard Deviation and Correlation Method

Beta can also be calculated by dividing –

Beta of Apple = 0.032/0.015 = 2.13

  • Standard Deviation of the return of the securities divided by the standard deviation of the benchmark returns.This value is then multiplied by the market and securities returns correlation.

Beta = 0.83 x (23.42% divided by 32.21%)= 0.60

How to Calculate Beta in Excel?

Below are the steps used to calculate Beta in excel. It can be easily calculated using the excel slope functionExcel Slope FunctionThe Slope function returns the slope of a regression line based on the data points recognized by known _y values and known _x values.read more –

Step 1: Get the stock’s weekly/monthly/quarterly prices.

Step 2: Get the index’s weekly/monthly/quarterly prices.

Step 3: Calculate the stock’s weekly/monthly/quarterly returns.

Step 4: Calculate the market’s weekly/monthly/quarterly returns.

Step 5: Use the slope function and select the return of the market and the stock

Step 6: The output of the slope is Beta

In the above example, we have calculated beta using the above steps. Return is calculated by dividing the old and new prices, subtracting one from it, and multiplying by a hundred.

These price returns are then used in calculating the slope function. In comparison to the market, the beta of the stock comes to 1.207. It means that the stock is more volatile than the market.

Advantages of Beta in Finance

  • Valuation: The most popular use of a beta is to calculate the cost of equityCost Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read more while conducting valuations. The CAPM uses beta to calculate the systematic risk of the market. In general, this can be used to value many companies with various capital structures.Volatility: Beta is a single measure that helps investors understand stock volatility compared to the market. It helps the portfolio managersThe Portfolio ManagersA portfolio manager is a financial market expert who strategically designs investment portfolios.read more assess the decisions regarding the addition and deletion of the security from his portfolio.Systematic Risk: Beta is a measure of systematic risk. Most of the portfolios have unsystematic risk eliminated from the portfolio. Beta only considers systematic risk and thereby provides the real picture of the portfolio.

Disadvantages of Beta in Finance

  • Beta can help to assess systematic riskAssess Systematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”.read more. However, it does not guarantee future returns. Beta can be calculated at various frequencies, including two months, six months, five years, etc. Using the past data cannot hold for the future. It makes it difficult for the user to predict the stock’s future movements.Beta is calculated based on the stock prices compared to the market prices. Therefore, it isn’t easy for startups or private companies to calculate beta. Conclusion: there are methods likeUnlevered beta is a measure to calculate the company’s volatility without debt concerning the overall market. In simple words, it is calculating the company’s beta without considering the effect of debt. Unlevered beta is also known as asset beta because the firm’s risk without debt is calculated just based on its asset.read more unleveraged betaUnleveraged BetaUnlevered beta is a measure to calculate the company’s volatility without debt concerning the overall market. In simple words, it is calculating the company’s beta without considering the effect of debt. Unlevered beta is also known as asset beta because the firm’s risk without debt is calculated just based on its asset.read more and leveraged betas, which also require many assumptions.Another drawback is that beta cannot tell the difference between an upswing and a downswing. It does not tell us when the stock was more volatile.

This article has been a guide to Beta in Finance and its definition. Here we discuss the calculation of Beta in Finance using its formula and examples and its interpretation, advantages, and disadvantages. You may learn more about Corporate Finance from the following articles –

  • What is Unsystematic Risk?Stock Beta FormulaBeta CoefficientFormula of Beta