Financial feeds like Yahoo Finance and Google Finance commonly list beta amid other financial data, such as stock price or market value. The beta refers to the sensitivity of the share price to an index or benchmark.
Key Takeaways
- Beta measures how sensitive a firm’s stock price is to an index or benchmark.
- A beta greater than 1 indicates that the firm’s stock price is more volatile than the market.
- A beta less than 1 indicates that the firm’s stock price is less volatile than the market.
- Microsoft Excel serves as a tool to organize data and calculate beta.
What Is Beta?
An index of 1.0 is commonly selected as the benchmark for a market index like the S&P 500 index. If a stock behaves more volatile than the market, its beta value will be greater than one. A company with a beta greater than one will tend to amplify market movements. If the opposite is true, its beta will be less than one. A business with a beta of less than one will tend to ease market movements.
Beta can be seen as a measure of risk. The higher the beta, the higher the expected return to compensate for the excess risk caused by volatility. From a portfolio management or investment perspective, investors analyze any measures of risk associated with a company to estimate expected return.
Methodology
The beta value provided on Google Finance may differ from the beta on Yahoo Finance or Reuters because of the various ways to estimate beta. Multiple factors, such as the time duration of the period, are included in the computation of the beta, which creates varying results. Some calculations base their data on three years, while others may use a five-year time horizon.
Investors should select the same beta methodology when comparing different stocks.
Calculating Beta
It’s simple to calculate the beta coefficient over a certain period. The beta coefficient needs a historical series of share prices for the company that is analyzed. In this historical example, Apple (AAPL) stock prices are used from 2012 through 2015 with the S&P 500 as the historical index found at:
Yahoo! Finance –> Historical prices, and download the time series “Adj Close” for the S&P 500 and the firm Apple.
The downloaded data from the S&P 500 will populate Excel as:
The downloaded data for Apple will appear in Excel as:
Formulas
The Excel table will download and the data can be reduced to three columns:
- Date
- Apple stock price
- Price of the S&P 500
There are two ways to determine beta. The first is to use the formula for beta, which is calculated as the covariance between the return (ra) of the stock and the return (rb) of the index divided by the variance of the index over three years.
βa=Var(rb)Cov(ra,rb)
First, add two columns to the spreadsheet: one with the index return r (daily in our case), (column E in Excel), and one with the performance of Apple stock (column D in Excel). The example considers the values of the last three years (about 750 days of trading) and a formula in Excel, to calculate beta.
BETA FORMULA = COVAR (D1: D749; E1: E749) / VAR (E1: E749)
The second method is to perform a linear regression, with the dependent variable performance of Apple stock over the last three years as an explanatory variable and the performance of the index over the same period.
With the results of the regression, the coefficient of the explanatory variable is the beta (the covariance divided by variance).
Using Excel, pick a cell and enter the formula: “SLOPE” which represents the linear regression applied between the two variables; the first for the series of daily returns of Apple (here: 750 periods), and the second for the daily performance series of the index, which follows the formula:
BETA FORMULA = SLOPE (E1: E749; D1:D749)
This computes a beta value for Apple’s stock (0.77 in the example, taking daily data and an estimated period of three years, from April 9, 2012, to April 9, 2015).
Low Beta vs. High Beta
For investors, incorporating low-beta stocks versus higher-beta stocks could serve as a form of downside protection in times of adverse market conditions. Low beta stocks are much less volatile, but intra-industry factors should be considered.
Higher beta stocks are commonly selected by investors who are keen and focused on short-term market swings. They wish to turn this volatility into profit, albeit with higher risks. Such investors would select stocks with a higher beta, which offer more ups and downs and entry points for trades than stocks with lower beta and lower volatility.
What Does a Stock’s Beta Mean for Investors?
The beta indicates its relative volatility compared to the broader equity market, as measured by indexes like the S&P 500, which has a beta of 1.0. A beta greater than one would indicate that the stock will go up more than the index when the index goes up but also fall more than the index when it declines. A beta of less than one would suggest more muted movements relative to the index.
How Is Beta Computed?
Beta is essentially the regression coefficient of a stock’s historical returns compared to those of the S&P 500 index. This coefficient represents the slope of a line of best fit correlating the stock’s returns against the index’s. Because regression coefficients are called “betas” (β) in statistics, the terminology was carried over to investing.
How Is Beta Used in Practice?
Beta is used to gauge the relative riskiness of a stock. As an example, consider the hypothetical firm US CORP (USCS). Financial websites provide a current beta for this company at 5.48, which means that for the historical variations of the stock compared to the Standard & Poor’s 500, US CORP increased on average by 5.48% if the S&P 500 rose by 1%. Conversely, when the S&P 500 is down 1%, US CORP Stock would tend to average a decline of 5.48%. If the index rose by 0,2%, USGC rose, on average, by 1.1%. As a result, one may conclude that USGC is a risky investment.
The Bottom Line
Investors should follow strict trading strategies and rules and apply a long-term money management discipline in all beta cases. Employing beta strategies can be used as part of a broader investment plan to limit downside risk or realize short-term gains, but also subject to the same levels of market volatility as any other trading strategy.
