Value of Beta Interpretation Example

< 0
Asset generally moves in the opposite
direction as compared to the index
Gold, which often moves opposite to the
movements of the stock market
= 0
Movement of the asset is uncorrelated with
the movement of the benchmark
Fixed-yield asset, whose growth is unrelated
to the movement of the stock market
0 < < 1
Movement of the asset is generally in the
same direction as, but less than the
movement of the benchmark
Stable, "staple" stock such as a company that
makes soap. Moves in the same direction as
the market at large, but less susceptible to
day-to-day fluctuation.
= 1
Movement of the asset is generally in the
same direction as, and about the same
amount as the movement of the benchmark
A representative stock, or a stock that is a
strong contributor to the index itself.
> 1
Movement of the asset is generally in the
same direction as, but more than the
movement of the benchmark
Volatile stock, such as a tech stock, or stocks
which are very strongly influenced by day-
to-day market news.
The formula for the beta of an asset within a
portfolio is
= Cov(Ra,Rb)/Var(Rb)
Ra is rate of return of asset under study.
Rb is rate of return of market.

Through regression:
Ra,t = a + a* Rm,t + e

There is no theoretically determined time period and
time intervals for calculating beta. The time period and
the time interval may vary.
The returns may be measured on a daily, weekly or
monthly basis. One should have sufficient number of
observations over a reasonable length of time.
Betas may not remain stable for a company over time
even if a company stays in the same industry. There
could be several reasons for this. Over time, a company
may witness changes in its product mix, technology,
competition or market share.



Nature of Business
Operating Leverage
Financial Leverage
6
If we regress a companys earnings with the aggregate
earnings of all companies in the economy, we would
obtain a sensitivity index, which we can call the
companys accounting beta.
The real or the market beta is based on share market
returns rather than earnings.
The accounting betas are significantly correlated with the
market betas. This implies that if a firms earnings are
more sensitive to business conditions, it is likely to have
higher beta.
We must distinguish between the earnings variability
and the earnings cyclicality.
The degree of operating leverage is defined
as the change in a companys earnings before
interest and tax due to change in sales.
Operating leverage intensifies the effect of
cyclicality on a companys earnings.
Financial leverage refers to debt in a firms
capital structure. Since financial leverage
increases the firms (financial) risk, it will
increase the equity beta of the firm.
For an unlevered (all-equity) firm, the asset beta
and the equity beta would be the same.
For a levered firm, the proportion of equity will
be less than 1. Therefore, the beta of asset will
be less than the beta of equity. The beta of
equity for a levered firm is given as follows:
Debt
1
Equity
E A
| |
(
= +
(

From the firms point of view, the expected
rate of return from a security of equivalent
risk is the cost of equity.
The expected rate of return or the cost of
equity in CAPM is given by the following
equation:

( )
j e f m f j
R k R R R | = = +
The use of the industry beta is preferable for
those companies whose operations match up
with the industry operations. The industry beta
is less affected by random variations.
Those companies that have operations quite
different from a large number of companies in
the industry, may stick to the use of their own
betas rather than the industry beta.
Beta estimation and selection is an art as well,
which one learns with experience.