Beta is a means of measuring a stock’s volatility relative to the market. Analyzing a stock’s technical and fundamental aspects can take you only so far when making investment decisions. The next step in your analysis is to find out how sensitive the stock in question is to changes in the overall market return.
What is Beta?
Beta is a standardized measure of a stock’s volatility relative to the market. It is also a key factor in structuring the capital asset pricing model (CAPM), which measures, in statistical terms, the required rate of return of an asset, or cost of equity, provided that asset is incorporated within a diversified portfolio and given that asset’s portion of risk that cannot be diversified away.
For instance, if all stocks in the S&P 500 Index were to exist completely uncorrelated to each other, then each stock would have a beta of zero. Furthermore, if all stocks had a beta of zero, then investors would be able to structure their portfolios to contain virtually no risk.
Of course, in reality, stocks are correlated, and particularly strongly if belonging to the same industry, or having similar market capitalization, or being almost equally prone to volatility during cycle swings, etc. At this point, we return to beta again, defining it as a tool that actually measures various stocks’ correlated risk.
It is generally accepted that an overall market, for example, the S&P 500, has a beta of 1.0, while individual stocks typically deviate up or down from that underlying beta. If a stock has a beta above 1.0, it is considered a more risky investment. In contrast, if a stock has a beta of less than 1.0, it means it fluctuates less than the market itself.
Therefore, the basic premise is that if you are an investor with low-risk tolerance, you will want to see a stock’s beta as close to 1.0 as possible. Of course, investors with a bit of a flair for speculation are likely to go for stocks with higher betas. After all, the higher the assumed risk, the higher the expected return.
Beta’s Advantages and Disadvantages
As with any other stock valuation ratio, the beta has its advantages and disadvantages. Determining a stock’s beta can tell you how much the stock deviates from the overall market, and it is a very simple and quantifiable method of measuring risk. However, one of the beta’s weaknesses is that it does not factor in new developments quickly enough.
For instance, let us assume that you have identified a company that has had a historically low beta. However, during the current quarter, there was a significant change at the company’s helm and the new management has decided to embark on an aggressive acquisition spree. To pay for it, the company had to assume considerably more debt. And while the stock’s beta still remained low, it obviously did not capture the company’s increased exposure to credit risk. Moreover, there are quite a few new companies in the capital market arena that have a relatively short price history, which makes it more difficult to come up with large enough statistics, and therefore, a reliable beta.
So, what is beta really good for? Agreed, beta is not a bulletproof risk measurement tool. However, it can be extremely useful when determining whether a stock is properly priced, undervalued, or overvalued through the CAPM model.