What it means
Imagine the market rises 10% in a year. A share with a beta of 1.5 would be expected to rise about 15%, and if the market fell 10% it would be expected to fall about 15%.
A share with a beta of 0.5 would rise or fall only about half as much as the market. Beta is calculated from past data by comparing a share's returns with market returns over the same periods.
The statistical method divides the covariance (how the two move together) by the variance of the market (how much the market itself moves). Most investors do not calculate it by hand, because data providers publish it.
Beta is a core input to the Capital Asset Pricing Model, or CAPM, which estimates the return investors should demand for taking on risk. Companies use CAPM to calculate their cost of equity, and that feeds into the discount rate used to value projects and businesses.
A higher beta means a higher required return and so a lower valuation, all else being equal. Different industries tend to have different betas.
Utilities and food producers are often defensive, with betas below 1, while technology, travel and luxury goods tend to be more sensitive to the economy and have betas above 1. A company's debt also raises its equity beta, because borrowing makes the returns to shareholders more volatile.
There are limits to beta. It describes only market-related risk and ignores risks specific to the company, and it is built from history that may not repeat.
Estimates change depending on the time period, the index and the return interval, so beta is best treated as a range rather than a precise number. For private companies, which have no share price, analysts often borrow the betas of listed competitors.
They remove the effect of the competitors' debt, then add back the debt level of the private business. This is called unlevering and relevering beta, and it is a standard step in company valuation.
In practice
Real-world examples
Example 1
An equity analyst compares two companies for a client who wants lower volatility. A supermarket chain has a beta of 0.6 and an airline has a beta of 1.4. She recommends the supermarket chain, explaining that it is expected to fall less when markets drop. She warns the client that the same shares would probably lag in a strong rally.
Example 2
A finance director estimates her company's cost of equity for a $20 million expansion. She uses a beta of 1.2, a risk-free rate of 4% and a market premium of 5%. Cost of equity = 4% + 1.2 x 5% = 10%, which becomes the starting point for the project's hurdle rate.
Example 3
A fund manager reviews a portfolio with a weighted average beta of 1.3 ahead of an expected downturn. To reduce risk, she sells part of a high-beta technology holding and buys a defensive utility. The portfolio beta falls to 1.0. She records the change in the investment committee minutes so the reasoning is on file.
Think of it
Beta is like measuring how much a boat rocks compared to average boats. High beta means bigger waves affect you more.
Formula
Calculation
Beta = Covariance of stock return and market return / Variance of market return
CAPM expected return = Risk-free rate + Beta x (Market return - Risk-free rate)
Suppose the covariance between a stock and the market is 0.0054 and the market's variance is 0.0036. Beta = 0.0054 / 0.0036 = 1.5. If the risk-free rate is 3% and the expected market return is 9%, the market risk premium is 9% - 3% = 6%. Expected return = 3% + 1.5 x 6% = 3% + 9% = 12%.Case study
Seen in the real world
Kestrel Components is a fictional electronics manufacturer considering a $5,000,000 new production line. The board asked the CFO what return the project needed to earn, and she estimated the company's beta at 1.4 from three years of weekly share prices.
Using a risk-free rate of 3% and a market premium of 6%, she calculated a cost of equity of 3% + 1.4 x 6% = 11.4% in this illustrative example. The project's expected return was only 10%, so the board delayed the investment and asked for a cheaper design. Months later the redesigned line offered a 13% return and was approved.
The CFO kept a note of the beta assumption and reran the estimate each year, because a different time window can shift the number. The board agreed to use a range of 1.2 to 1.5 in future decisions rather than a single figure.
Watch out
Common mistakes
- Reading beta as a measure of total risk. It captures only sensitivity to the market and ignores company-specific risks.
- Assuming a low beta means a safe investment. A share can have a low beta and still lose money because of problems in the business.
- Using beta from a different time period or index without noticing. The result can change a lot depending on how it is calculated.
Questions
People also ask
Can beta be negative?
Yes, a negative beta means the asset tends to move in the opposite direction to the market, although it is rare in practice.
Is a high beta good or bad?
It depends on your view, since high-beta shares tend to gain more in rising markets and lose more in falling ones.
How does debt affect beta?
More borrowing usually raises the equity beta, because shareholders' returns become more volatile.
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