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Wednesday, February 2, 2011

What is the beta coefficient of a stock?

The beta coefficient, also represented by the Greek letter Beta, or the English letter B. Beta is a measure of risk most notably in regard to equities traded in stock markets. The beta determines price movement relationships alongside broader market indicators such as an index or group of stocks.

The closer the beta value is to the integer 1, the more probable that stock is to move in tandem with broader market movements such as the index. It is important to note, the beta coefficient is calculated using historical prices and should not be interpreted to indicate an exact measurement of future price movements.

Key attributes of the beta coefficient


The beta coefficient has several functions and attributes that make it a unique and important financial equation. The beta is considered a standard statistic in financial analysis and is used in a number of other more complex formulas. A few of the specific features of the beta are listed below:

• Establishes numerical relationships between stock prices and markets over time
• Is an accurate measure of historical price volatility
• Beta is also used in the Capital asset pricing model (CAPM)
• Can be calculated quickly and easily in a number of ways
• Assists in determining price risk
• Calculated using percentage rates of return for 2 or more points in time.

How to calculate the beta coefficient


There are several ways to obtain a beta value including the Microsoft excel statistical tool, a financial calculator, an online financial analysis website or manually using a formula. It can be helpful to understand the math behind a beta in understanding what the beta is. One simple method to calculate the beta is the rise over run method (Brigham and Houston p.277) This method simply takes two historical percentage price points and subtracts them and then divides the difference between corresponding percentage price points in the index.

Beta=Rise over Run=Change in Y (Stock price)/Change in X (Index value)

For example, when company Y had a rate of return of 7% dollars, the index had a return of 5%, and when the index had a return of 2% , company Y had a return of 4%. Using the rise over run equation, the change in company Y (also plotted on the Y axis of a graph) is 3% and the change in the rate of return of the index is 2%.

The change in Y divided by the change in X is equal to 1.5 which is the beta. Since a beta of 1 represents an exact historical price correlation, values higher than 1 are less correlated i.e. numerically related than betas of 1. The further a beta gets from the value 1, the less likely the stock being measured will move with the index if the historical relationship remains constant.

Advantages and disadvantages of the beta coefficient


The beta value is a useful tool to measure price relationships under various market conditions. For example, if there is a recession, a stock with a historical beta of 1 is statistically more probable to also decline in price than a stock with a beta of 2. This is because the stock with a beta of 2 does not necessarily follow market trends. There are several advantages to using beta, most importantly its ability to determine price stability over time. It can also be calculated using many points in time thereby augmenting its statistical validity.

On the other hand, the beta coefficient does have a few disadvantages. Since the calculation is limited i.e. only uses two variables as changed over time, it does not take into account other variables such as inflationary pressures, capital liquidity, financial ratios etc. Such being the case, the beta is restricted to being a potential indicator of price movement in relation to a broader index. Additionally, since market and company conditions can change over time, the beta will not take into account these future changes.

The beta coefficient is a mathematical value that represents risk of a financial instrument over time in relation to a market. The beta can be easily calculated or obtained and is a standard financial value used in financial analysis. The beta coefficient is a statistical tool based on historical trends and price movements and is therefore not an exact indicator of future price relationships. Rather, the beta coefficient is a useful estimator for determining future price relationships and risk of a particular company or stock.

The beta can be determined under various market conditions to enhance risk and return predictions for a particular asset and/or equity product and can also be calculated using an adjustable range of percentage returns over time. Since the beta value is limited by its variables, it is narrow in its predictive ability. However, the beta coefficient is also an important variable in other financial equations such as the capital asset pricing model (CAPM) and in regression analysis.

For additional information on the beta coefficient, please feel free to scroll through the slides below:

Sources:

1. Calculating Beta using excel: http://faculty.babson.edu/academic/Beta/CalculateBeta.htm
2. Eugene F. Brigham, and Joel F. Houston. Fundamentals of Financial Management 9th Ed. South-Western, 1999.p277-281.
3. Howard Bryan Bonham CPA, The complete Investment and Finance Dictionary. Avon Media Corporation, 2001.p.62
4. Zvi Bodei, Alex Kane and Alan J.Marcus. 'Investments' Mcraw-Hill Irwin. New York, 2002. P. 265-271