Summer’s Finance Compendium

How do you calculate beta to find cost of equity?

What is the value of beta for different sectors?

Submitted by:
Mridul Gupta (107), O R Venkatesh (112), Sumit Chokhani(133), Neha
Bhargava(110), Santharam Dharamlingam(125), Karanam Tarun(101),Sabarish A
S(53), AnupKumar(7), Kanika Juneja(30)

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Cost of equity
The annual rate of return that an investor expects to earn when investing in shares of a
company is known as the cost of equity. That return is composed of the dividends paid on
the shares and any increase (or decrease) in the market value of the shares. For example, if
an investor expects a 10% return from McDonald's stock and she buys a share at $67.25,
her expectation is to receive $6.72 during the year through a combination of dividends
(currently $.34 per share during 1998) and the appreciation of the stock price (presumed to
be $6.38 to give her the 10% expected return totaling $6.72) during the year.
The return expected of any risky common stock should be composed of at least three
different return components:
(1) a return commensurate with a risk-free security (Rf);
(2) a return that incorporates the market risk associated with common stocks as a whole
(Rm); and
(3) a return that incorporates the business and financial risks specific to the stock of the
company itself, known as the company's beta.

The first measure of return (Rf) relates to what market rate of return is currently available
from a risk-free security, like the yield associated with a long-term Treasury Bond. So if the
yield on Treasury Bonds is 5%, an investor should expect a return greater than 5% for a
common stock.

The second measure of return (Rm) relates to what market returns are currently available
from and what risks are associated with stocks in general. There is a general risk premium
(the equity risk premium) associated with the stock market as a whole. That risk premium
should be priced into any equity investment. For example, if you expect to earn 8% on
average (from a diversified portfolio) in the stock market and the risk-free rate is 5%, the
Equity Risk Premium (Rerp) would be (Rerp) = (8% - 5%)= 3%.
Equity Risk Premium(Rerp) = Exp. Return on Market(Rm) - Risk Free Rate(Rf)

The third measure of return versus risk (beta) should be related to the specific stock being
purchased. Beta measures the risk of the company relative to the risk of the stock market in
general. With greater risk, as measured by a larger variability of returns the company's
should have a larger beta. And with greater leverage (higher debt to value ratio) increasing
financial risk, the company's stock should also have a larger beta. And with a larger beta,
an investor should expect a greater return. The beta of an average risk firm in the stock
market is 1.00.

Beta = covariance(stock, market)/variance of the stock

It is a measure of the sensitivity of the stock/share/portfolio with respect to the

market/index......like if the index rises by 2% and the beta of stock a is 1.7 then the price of
the stock shall rise by 2% * 1.7 = 3.4%......

The financial risk model that uses beta as its sole measure of risk ( a single factor model) is
called the Capital Asset Pricing Model (CAPM) and is used by many market analysts in
their valuation process. The relationship between risk and return that comes out of that
model and the one that is incorporated into our FCFF analysis and spreadsheet software is:
Exp.(Rs) = (Rf) + beta(Rerp)
which in English translates to "The expected return on a stock (e.g. McDonald's) is equal to
the risk free rate (e.g. 5%) plus the specific stock's beta (e.g. 0.97) times the equity risk

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premium (e.g. 3.0%)." In numbers it looks like this: Expected Return on McDonald's Stock =
5% + 0.97(3.0%) = 7.91

It is important that one follows the Beta value as it tells us the volatility of a stock in
comparison with the prevailing index. The point is to note that Low-beta stocks make Nifty
less volatile and viceversa is also true. Beta=1 means that stock is moving in corelation with
the index and one can almost expect returns equivalent to the index movement. Defensives
stocks like like pharma and FMCG generally have low beta value and is thus absorbing more
volatility in the index by virtue of their inclusion.

To put the same in more easier language one can say that a low-beta stock means the stock
price is less sensitive to the market movement. Hindustan Unilever, for instance, has a beta
of 0.56, while DLF is around 1.5 and that explains the high volatility in the latter’s stock price.
The beta compares the sensitivity of a stock’s price movement with the broader index.
Higher the beta, higher will be the volatility in the stock price, and hence, riskier the
investments. Lesser the beta, lesser will be the volatility in the stock price, and hence, it will
be safer to invest in that stock.

S.no Company Sector Beta value

1 ACC Cement 0.73

2 Ambuja cements Cement 0.86

3 Axis bank Financial service 1.26

4 Bharti Airtel Telecom 0.99

5 BPCL Oil 0.43

6 Cairn India Oil 1.1

7 Cipla Pharma 0.51

8 HCL IT 1.09

9 Hero Honda Automobile 0.45

10 ITC FMCG 0.5

11 HUL FMCG 0.41

12 ONGC Oil 0.89

13 Reliance Telecom 1.52

Communications

14 SAIL Steel 1.31

15 SunPharma Pharma 0.41

16 TATACOM Telecom 0.9

17 TATA Power Power 0.91

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18 TATA Steel Steel 1.46

19 TCS IT 0.89

20 Unitech Real Estate 1.70