Equities

Beta: Know The Risk

How should investors assess risk in the stocks they buy or sell? As you can imagine, the concept of risk is hard to pin down and factor into stock analysis and valuation. Is there a rating – some sort of number, letter or phrase – that will do the trick?

One of the most popular indicators of risk is a statistical measure called beta. Stock analysts use this measure all the time to get a sense of stocks’ risk profiles.

Here we shed some light on what the measure means for investors. While beta does say something about price risk, it has its limits for investors looking for fundamental risk factors.

Beta

Beta is a measure of a stock’s volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock’s beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.

Beta is a key component for the capital asset pricing model (CAPM), which is used to calculate cost of equity. Recall that the cost of capital represents the discount rate used to arrive at the present value of a company’s future cash flows. All things being equal, the higher a company’s beta is, the higher its cost of capital discount rate. The higher the discount rate, the lower the present value placed on the company’s future cash flows. In short, beta can impact a company’s share valuation.

Advantages of Beta

To followers of CAPM, beta is a useful measure. A stock’s price variability is important to consider when assessing risk. Indeed, if you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk.

Intuitively, it makes plenty of sense. Think of an early-stage technology stock with a price that bounces up and down more than the market. It’s hard not to think that stock will be riskier than, say, a safe-haven utility industry stock with a low beta.

Besides, beta offers a clear, quantifiable measure, which makes it easy to work with. Sure, there are variations on beta depending on things such as the market index used and the time period measured, but broadly speaking, the notion of beta is fairly straightforward to understand. It’s a convenient measure that can be used to calculate the costs of equity used in a valuation method that discounts cash flows.

Disadvantages of Beta

However, if you are investing in a stock’s fundamentals, beta has plenty of shortcomings.

For starters, beta doesn’t incorporate new information. Consider a utility company, let’s call it Company X. Company X has been considered a defensive stock with a low beta. When it entered the merchant energy business and assumed high debt levels, X’s historic beta no longer captured the substantial risks the company took on. At the same time, many technology stocks are relatively new to the market and thus have insufficient price history to establish a reliable beta.

Another troubling factor is that past price movements are very poor predictors of the future. Betas are merely rear-view mirrors, reflecting very little of what lies ahead.

Furthermore, the beta measure on a single stock tends to flip around over time, which makes it unreliable. Granted, for traders looking to buy and sell stocks within short time periods, beta is a fairly good risk metric. However, for investors with long-term horizons, it’s less useful.

Re-Assessing Risk

The well-worn definition of risk is the possibility of suffering a loss. Of course, when investors consider risk, they are thinking about the chance that the stock they buy will decrease in value. The trouble is that beta, as a proxy for risk, doesn’t distinguish between upside and downside price movements. For most investors, downside movements are risk while upside ones mean opportunity. Beta doesn’t help investors tell the difference. For most investors, that doesn’t make much sense.

There is an interesting quote from Warren Buffett in regards to the academic community and its attitude towards value investing: “Well, it may be all right in practice, but it will never work in theory.” Value investors scorn the idea of beta because it implies that a stock that has fallen sharply in value is more risky than it was before it fell. A value investor would argue that a company represents a lower-risk investment after it falls in value – investors can get the same stock at a lower price despite the rise in the stock’s beta following its decline. Beta says nothing about the price paid for the stock in relation to its future cash flows.

If you are a fundamental investor, consider some practical recommendations offered by Benjamin Graham and his modern adherents. Try to spot well-run companies with a “margin of safety” – that is, an ability to withstand unpleasant surprises. Some elements of safety come from the balance sheet, like having a low ratio of debt to total capital. Some come from consistency of growth, in earnings or dividends. An important one comes from not overpaying. Stocks trading at low multiples of their earnings are safer than stocks at high multiples.

In Summary

It’s important for investors to make the distinction between short-term risk – where beta and price volatility are useful – and longer-term, fundamental risk, where big-picture risk factors are more telling. High betas may mean price volatility over the near term, but they don’t always rule out long-term opportunities.

Ben McClure can be contacted at BayofThermi.com

 

 

Ben has been working with technology start-ups on strategy, finance, valuation, partnerships and fundraisings for over ten years. He has been involved with more than 100 companies across a broad range of technology industries – from biotech and medical devices, to Internet and mobile telecoms software and hardware, to clean-tech and energy – in Europe, North America and Latin America. He has served as an advisor to venture capital and early-stage investment funds.

Ben has produced investor-ready business plans, valuations and presentations that have been used to guide growth and successfully raise more than $100 million for start-up and early stage technology ventures. He has been involved in three IPOs, in addition to numerous private investments, technology licensing agreements and business development deals.

A regular and long-time contributor to Investopedia.com, he is author of the Discounted Cash Flow Tutorial and Valuing Biotech Companies Using DCF. Ben also writes the Bay of Thermi Blog. For five years Ben judged business plans for the annual TEC Edmonton Venture Prize Business Plan Competition and served as a judge for theNCET2(National Council of Entrepreneurial Technology Transfer) University Technology Business Plan Competition. He lectures Technology Commercialization/Entrepreneurship at the University of Sheffield’s City College, Executive MBA Program.

Ben has been working with technology start-ups on strategy, finance, valuation, partnerships and fundraisings for over ten years. He has been involved...

TradeFollowr

Newbie
2 0
Beta by itself is not very useful, other than to filter for higher or lower average volatility. While higher beta overall deotes higher risk, it also denotes higher returns usually. It is the correlation of beta to the markets that shifts over time - high beta stocks can go through periods of low volatility, low beta stocks can do the opposite.

It is when this beta gets correlated to market moves that the risk comes into play - the market is up 1% but the stock is up 4% type of thing. The correlation depends on several factors - sector money flows, economic outlook for that sector, state of the economy etc.

Beta is an averaging tool that takes into accounts large periods of time which kind of "pools" all price action together and does not always reflect risks on a shorter timeframe.
 

MACLondon

Junior member
43 1
The statistics of beta....it's not a one man pony

Also - one of the most common errors in Beta - often overlooked by less mathematically inclined people is that: By construction Beta is just the product of whatever particular time period you choose...what i mean is that lots of people will look at the beta of a stock, let's say it's 0.5. And they'll assume that if the market's up 1% the stock will be +0.5%. Problem is that typically beta is calculated on fornightly movements for two years. Clearly that has little relevance for the movement of a stock throughout the day. Remember that if you're going to look at past data to infer indeas and risk, then the data set that you look at must be the same periodicity as that which you're trading. E.g. if you want to look at daily stocks, look at a daily beta; hourly trading, look at hourly betas. This idea that "BETA" is tjust this static, immovable risk measure is a false assumption...it's like looking at a monthly indicatior to show you hourly behaviour. Good article, and yes obviously beta has nothing to do with the fundamentals of a stock. But remember to get the statistics right guys if you're going to look at things like this.
 

MACLondon

Junior member
43 1
Beta by itself is not very useful, other than to filter for higher or lower average volatility. While higher beta overall deotes higher risk, it also denotes higher returns usually. It is the correlation of beta to the markets that shifts over time - high beta stocks can go through periods of low volatility, low beta stocks can do the opposite.

It is when this beta gets correlated to market moves that the risk comes into play - the market is up 1% but the stock is up 4% type of thing. The correlation depends on several factors - sector money flows, economic outlook for that sector, state of the economy etc.

Beta is an averaging tool that takes into accounts large periods of time which kind of "pools" all price action together and does not always reflect risks on a shorter timeframe.

Errr....that doesn't make sense...at all. Correlation of beta to the market. Beta is not a constant. It doesn't correlate to the market. There is no secondary derderivative of beta? The reason you're seeing your beta as being a bad predictor of the your stock is due to the exact reason i first stated. You're looking at a beta calculated from the wrong periodicity. It's nothing to do with it's correlation to the market. Also you're confusing stats with fundamentals. Clearly beta does not account for all extreme moves in a stock...as like the initial article rightly mentions, you can correctly calculate beta but if the stock declares itself bankrupt tomorrow it doesn't matter how good your beta is it's not going to predict it. Beta is an EX-POST calculation.
 

bansir

Well-known member
494 42
very useful, thanks
 

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