What it means
An individual share's price moves for two kinds of reason: things specific to the company (a product launch, a lawsuit, a profit warning) and things affecting the whole market (interest rates, recessions, investor sentiment). The first kind can be diversified away by holding many shares, because company-specific events cancel out across a portfolio.
The second kind cannot, because every share is exposed to it. Beta measures how exposed a particular share is to that market-wide movement.
Statistically, beta is the slope of the line that best fits the share's returns plotted against the market's returns over some period, typically two to five years of monthly or weekly data. It equals the covariance of the share's returns with the market's, divided by the variance of the market's returns.
A share whose returns closely track the market has a beta near 1.0 and a tight fit; a share that moves erratically has a beta that may be high or low but a loose fit, meaning much of its risk is company-specific rather than market-driven. Beta's main use is in the Capital Asset Pricing Model, which says that an investment's expected return equals the risk-free rate plus beta times the market risk premium.
A high-beta share should earn more than the market in the long run, because investors demand compensation for its greater sensitivity to downturns; a low-beta share should earn less. Companies use beta to estimate their cost of equity for investment appraisal and valuation; fund managers use it to position portfolios (raising beta when they expect the market to rise, lowering it when they expect a fall) and to explain performance.
Beta has well-known limitations. It is estimated from history and can change as a company's business or leverage changes.
It depends on the period, the frequency of data and the choice of market index, and different sources report different figures for the same share. It captures only market risk, so a low-beta company can still be very risky in its own right.
And the theory it rests on has been challenged by evidence that low-beta stocks have historically earned more than the model predicts. Beta remains the standard measure of market risk because nothing simpler has replaced it, but it is an estimate, not a fact.
In practice
Real-world examples.
Example
A consumer staples company has a beta of 0.55; its sales of food and household goods barely change in recessions, so its shares fall less than the market in downturns.
Example
A cyclical airline has a beta of 1.8; its profits swing with the economy and its shares amplify market moves.
Example
A gold mining company has a beta near zero or slightly negative, because gold often rises when equities fall.
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 (Return on the investment, Return on the market) / Variance (Return on the market)
Expected Return (CAPM) = Risk-free Rate + Beta x (Expected Market Return minus Risk-free Rate)
Portfolio Beta = Sum of (Weight of each holding x Beta of each holding)
Worked example 1, using beta. The risk-free rate is 4% and the expected market return is 10%, so the market risk premium is 6%.
- A utility with beta 0.6: expected return = 4% + 0.6 x 6% = 7.6%
- The market (beta 1.0): expected return = 10%
- A technology company with beta 1.4: expected return = 4% + 1.4 x 6% = 12.4%
A company with beta 1.4 evaluating a project should require a return of at least 12.4% on equity-financed investment; using the market's 10% would understate the hurdle.
Worked example 2, estimating beta from data. Over five periods, a share and the market returned:
- Period 1: share +8%, market +5%
- Period 2: share minus 4%, market minus 2%
- Period 3: share +12%, market +7%
- Period 4: share +2%, market +1%
- Period 5: share minus 10%, market minus 6%
Market mean = 1.0%; share mean = 1.6%. Covariance = sum of (share deviation x market deviation) / 5 = [(6.4 x 4) + (minus 5.6 x minus 3) + (10.4 x 6) + (0.4 x 0) + (minus 11.6 x minus 7)] / 5 = (25.6 + 16.8 + 62.4 + 0 + 81.2) / 5 = 37.2. Market variance = (16 + 9 + 36 + 0 + 49) / 5 = 22.0. Beta = 37.2 / 22.0 = 1.69.
The share moves about 1.7 times as much as the market. In practice, far more than five observations are used, but the calculation is the same.
Worked example 3, a portfolio. A portfolio is 40% in a fund with beta 1.2, 40% in a fund with beta 0.9 and 20% in cash (beta 0). Portfolio beta = 0.4 x 1.2 + 0.4 x 0.9 + 0.2 x 0 = 0.84. If the market falls 10%, the portfolio would be expected to fall about 8.4%.Case study
Seen in the real world.
A manufacturing company used a discount rate of 8% for all its investment projects, a figure set years earlier and never revisited. Its finance director recalculated the cost of equity using a current beta of 1.3 (up from 0.9, because the company had taken on debt and expanded into a more cyclical product line), a risk-free rate of 4% and a market premium of 6%: 4% + 1.3 x 6% = 11.8%. Blended with the cost of debt, the weighted average cost of capital was 9.7%, nearly two points above the rate in use.
Re-running the last three years of approved projects at the correct rate showed that four of them, all marginal at 8%, would have been rejected at 9.7%, and two of those were now underperforming exactly as the higher rate would have predicted. The company adopted a policy of recalculating its beta and cost of capital annually, and of applying a higher rate to projects in its more cyclical division than to its stable one.
Watch out
Common mistakes.
- Treating beta as a fixed property of a company. It changes with the business mix, leverage and the estimation period.
- Reading low beta as low risk in every sense. Beta measures market risk only; a company can have a low beta and still fail for its own reasons.
- Using a beta estimated against the wrong market index or over an unrepresentative period.
Questions
People also ask.
What does a beta of 1 mean?
The investment tends to move in line with the market: a 10% market rise or fall is expected to produce a 10% move in the investment.
Can beta be negative?
Yes, though rarely for ordinary shares. Assets that tend to rise when the market falls, such as some gold-related investments and certain hedging strategies, have negative betas.
How is beta used in valuation?
It sets the cost of equity in the Capital Asset Pricing Model, which feeds the discount rate used to value a company's cash flows. A higher beta means a higher discount rate and a lower valuation.
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