CAPM Beta When we invest in stock markets, how do we know that stock A is less risky than stock B. Differences can arise due to market capitalizationMarket capitalization is the market value of a company’s outstanding shares. It is computed as the product of the total number of outstanding shares and the price of each share.read more, revenue size, sector, growth, management, etc. Can we find a single measure that tells us which stock is riskier? The answer is YES, and we call this as CAPM Beta or Capital Asset Pricing Model Beta. In this article, we look at the nuts and bolts of CAPM Beta – What is the CAPM Beta?Beta is a very important measure that is used as a key input for Discounted Cash Flow or DCF valuationsDiscounted 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. CAPM Beta FormulaIf you have a slightest of the hint regarding DCF, then you would have heard about the Capital Asset Pricing Model (CAPMThe 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) that calculates the Cost 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 as per the below Beta formula. Cost of Equity = Risk Free Rate + Beta x Risk Premium  You are free to use this image on your website, templates, etc, Please provide us with an attribution link Article Link to be HyperlinkedFor eg: Source: CAPM Beta (wallstreetmojo.com) If you have not heard of Beta yet, then worry not. This article explains to you about Beta in the most basic way. Let us take an example: when we invest in stocks, it is but human to pick stocks that have the highest possible returns. However, if one chases only returns, the other corresponding element is missed, i.e., Risk. Actually, every stock is exposed to two types of risks. What is Beta?Basic Definition of Beta – Beta measures the stock risks in relation to the overall market. You are free to use this image on your website, templates, etc, Please provide us with an attribution link Article Link to be HyperlinkedFor eg: Source: CAPM Beta (wallstreetmojo.com)
In general, large companies with more predictable Financial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more and profitability will have a lower beta value. For example, Energy, Utilities, and Banks, etc., all tend to have a lower beta. Most betas normally fall between 0.1 and 2.0 though negative and higher numbers are possible. Key Determinants of BetaNow that we understood Beta as a measure of Risk, it is important for us to also understand the sources of risks. Beta depends on a lot of factors – usually, the nature of the business, operating and financial leverages, etc. The below diagram shows the key determinants of Beta – You are free to use this image on your website, templates, etc, Please provide us with an attribution link Article Link to be HyperlinkedFor eg: Source: CAPM Beta (wallstreetmojo.com) High Beta Stocks/SectorsDue to the uncertain economic environment, questions always remain on what is the best investment strategyInvestment strategies assist investors in determining where and how to invest based on their expected return, risk appetite, corpus amount, holding period, retirement age, industry of choice, and so on.read more. Should I pick high CAPM Beta stocks or Low CAPM Beta Stocks? It is normally understood that cyclical stocks have high Beta and defensive sectors have low Beta. Cyclical stocks are those whose business performance and stock performance is highly correlated with economic activities. If the economy is in recession, then these stocks exhibit poor results, and thereby stock performance takes a beating. Likewise, if the economy is on a high growth trajectory, cyclical stocksA cyclical stock refers to that share whose price fluctuates with the change in overall macroeconomic conditions. Such a stock is sensitive to the various economic phases like recession, boom, expansion, contraction, trough, peak and recovery.read more tend to be highly correlated and demonstrate a high growth rate in business and stock performances. Take, for example, General Motors; its CAPM Beta is 1.43. This implies if the stock market moves up by 5%, then General Motors stock will move up by 5 x 1.43 = 7.15%. The following sectors can be classified as cyclical sectors and tend to exhibit High Stock Betas.
Low Beta Stocks/SectorsLow Beta is demonstrated by stocks in the defensive sector. Defensive stocksA Defensive Stock is a stock that provides steady growth and earnings to the investors in the form of dividends irrespective of the state of the economy as it has a low correlation with the overall stock market/economy and is therefore insulated from changing business cycles.read more are stocks whose business activities and stock prices are not correlated with economic activities. Even if the economy is in recession, these stocks tend to show stable revenues and stock prices. For example, PepsiCo, its stock beta is 0.78. If the stock market moves down by 5%, then Pepsico stock will only move down by 0.78×5 = 3.9%. The following sectors can be classified as defensive sectors and tend to exhibit Low Stock Betas-
CAPM Beta Calculation in ExcelTechnically speaking, Beta is a measure of stock price variability in relation to the overall stock market (NYSE, NASDAQ, etc.). Beta is calculated by regressing the percentage change in stock prices versus the percentage change in the overall stock market. CAPM Beta calculation can be done very easily on excel. Let us calculate the Beta of MakeMyTrip (MMTY) and Market Index as NASDAQ. Step 1 – Download the Stock Prices & Index Data for the past 3 years.The first step is to download the stock price and Index data. For NASDAQ, download the dataset from Yahoo Finance. Likewise, download the corresponding stock price data for the MakeMyTrip example from here. Once you have downloaded the data set for the two, please do the following for each of the data set-
Step 3 – Prepare a single sheet of Stock Prices Data & Index Data.Step 4 – Calculate the Fractional Daily ReturnStep 5 – Calculate Beta – Three MethodsYou can use either of the three methods to calculate Beta – 1) Variance/Covariance Method 2) SLOPE Function in excelThe 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 3) Data Regression
Using the variance-covariance method, we get the Beta as 0.9859 (Beta Coefficient) Using this SLOPE function method, we again get the Beta as 0.9859 (Beta Coefficient)
For using this function in excel, you need to go to the Data Tab and select Data Analysis. If you are unable to locate Data Analysis in Excel, then you need to install the Analysis ToolPak. This process is relatively easy: Go to FILE -> Options -> Add-Ins -> Analysis ToolPakExcel's data analysis toolpak can be used by users to perform data analysis and other important calculations. It can be manually enabled from the addins section of the files tab by clicking on manage addins, and then checking analysis toolpak.read more -> Go -> Check Analysis ToolPak -> OK Select Data Analysis and click on Regression. Choose the Y Input Range and X Input Range Once you click OK, you get the following Summary Output As noted above, you get the same answer of Beta (Beta Coefficient) in each of the methods. Also, note that MakeMyTrip beta is approximately closer to 1.0, this implies that MakeMyTrip stock prices have the same level of risk as to the broad NASDAQ Index. Levered vs. Unlevered BetaLevered Beta or Equity BetaEquity Beta measures the volatility of the stock to the market, i.e., how sensitive is the stock price to a change in the overall market. It compares the volatility associated with the change in prices of a security. Equity Beta is commonly referred to as levered beta, i.e., a firm's beta, which has financial leverage.read more is the Beta that contains the effect of capital structure, i.e., Debt and Equity both. The beta that we calculated above is the Levered Beta. Unlevered Beta is the Beta after removing the effects of the capital structure. As seen above, once we remove the financial leverage effect, we will be able to calculate Unlevered 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. Unlevered Beta can be calculated using the following formula – Beta (Unlevered) = Beta (levered)/ (1+ (1-tax) * (Debt/Equity)) As an example, let us find out the Unlevered Beta for MakeMyTrip. Debt to Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. read more (MakeMyTrip) = 0.27 Tax Rate = 30% (assumed) Beta (levered) = 0.9859 (from above) Beta (Unlevered) = 0.9859 / (1+ (1-30) * 0.27) Beta (Unlevered) = 0.8291 Calculate Beta of an Unlisted or Private CompanyAs seen earlier, Beta is a statistical measure of the variability of a company’s stock price in relation to the stock market overall. However, when we evaluate private companiesA privately held company refers to the separate legal entity registered with SEC having a limited number of outstanding share capital and shareowners. read more (not listed), then how we should find Beta? In this case, Beta does not exist; however, we can find an IMPLIED BETA from the comparable companies analysisComparable comps are nothing but identifying relative valuations like an expert to find the firm's fair value. The comparable comp process starts with identifying the comparable companies, then selecting the right valuation tools, and finally preparing a table that can provide easy inferences about the fair valuation of the industry and the company.read more. Implied Beta is found using the following 3 step process – Step 1 – Find all the Listed Comparables whose Beta’s are readily available.Please note that the Betas that you download are Levered BetasLevered beta measures the systematic risk of a stock that includes risk due to macroeconomic events like war, political events, recession, etc. Systematic risk is inherent to the entire market and is also known as undiversifiable risk.read more, and hence, it is important to remove the effect of capital structure. The higher amount of debt implies higher variability in earnings (Financial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more), which in turn results in higher sensitivity to the stock prices. Let us assume here that we want to find the Beta of a private company, let’s call this as PRIVATE. As a first step, we find all the listed peers and identify their Betas (levered) Step 2 – Unlever the BetasWe will use the formula discussed above to Unlever the Beta. Beta (Unlevered) = Beta (levered)/ (1+ (1-tax) * (Debt/Equity)) Please note that for each of the competitors, you will have to find additional information like Debt to Equity and Tax Rates. While unlevering, we will be able to remove the effect of financial leverage. Step 3: Relever the BetaWe then relever the beta at an optimal capital structure of the PRIVATE company as defined by industry parameters or management expectations. In this case, ABC company is assumed to have a Debt/Equity of 0.25x and a Tax Rate of 30%. The calculation for the relevered beta is as follows: It is this relevered Beta that is used for calculating the Cost of EquityCost of Equity (Ke) is what shareholders expect for investing their equity into the firm. Cost of equity = Risk free rate of return + Beta * (market rate of return - risk free rate of return). read more of the Private companies. What Does a Negative Beta Mean?Though in the above cases, we saw that Beta was greater than zero; however, there may be stocks that have negative betas. Theoretically, the negative beta would mean that the stock moves in the opposite direction of the overall stock market. Though these stocks are rate, they do exist. Many companies that are into gold investing can have negative betas because gold and stock markets move in the opposite direction. International companies may also have negative beta as their business may not be directly linked to the domestic economy. If you are curious to see some examples of Negative Beta Stocks, here is the process through which you can hunt for negative beta stocks. Step 1 – Visit Yahoo ScreenerStep 2 – Choose the Industry FilterYou may choose the sector/industry of your choice. I have picked up Gold (Basic Materials) Step 3 – Choose the Beta Values Minimum and MaximumStep 4 – Click on Find Stocks, and you will see the list belowStep 5 – Sort the Beta column from Low to HighStep 6 – Enjoy the list of Negative Betas :-) Advantages of CAPM BetaDisadvantages of CAPM Beta
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A method to determine market risk using the betas of single-product companies in a given industry.
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