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Investment Tips by AnalysisTime – Beta Value

August 27, 2013
By Gulshan Malhotra

Overview

This article is a communication regarding the importance of beta value in the analysis. A stock analysis helps an investor to understand the behaviour of the stock. It also helps to know and comprehend the grounds for a spike or dip with regards to a stock value.

Beta Value

By definition as per Wikipedia, the beta (β) of a stock or portfolio is a number of describing the correlated volatility of an asset in relation to the volatility of the benchmark that the asset is being compared to. This benchmark or criterion is generally the overall financial market and is often estimated via the use of representative indices, such as the S&P 500. “Beta determines systematic risk based on how returns co-move with the overall market.”

The formula for the beta of an asset within a portfolio is

β = 

Covariance of Market Return with Stock Return

Variance of Market Return

Or
β = 

Correlation Coefficient

 × 

Standard Deviation of Stock Returns

Between Market and Stock

Standard Deviation of Market Returns

Analysis

A stock has more than one driver for volatility, for instance

a)
Stock Price: Let me explain this by an example of Gold Corp (Ticker: G) vs Yamaha Gold (Ticker: YRI). Both the companies are in gold mining. It does not mean that the instability for both will be the same ,one of the reasons being the stock price. As on Aug 14, 2012, G price was $30.35 while YRI price was $11.16. Since YRI price of $11.16 is significantly lower than the price of G which is $30.35, it will have admittance to larger group of investors than G. In other words, YRI demand will be higher than the G. So, you can expect YRI beta will be higher than the G.

b) Industry: Each industry is different in terms of volatility. For instance,the Information Technology industry is highly dependent on innovation which leads to increase in the risk with regards to business. Since the business is highly risky, investor requires higher return on equity (ROE), which also attracts larger number of investors. The beta value for the information technology companies can be higher than other sector’s companies.

Beta Value helps to distinguish one stock from the other in terms of volatility. If any stock is having higher volatility, it has higher risk. So, an investor should expect higher return from the higher beta value stock. In our above example of G, the beta value is 0.92 compared to YRI beta value of 1.13. So,the Investor’s expected rate of return (by use Capital Assets Pricing Method; CAPM) of G is 9% while 10% for YRI. It implies a higher risk rate than return, if an investors return from YRI is 9%. While the same return will be considered as a satisfactory return and match the risk associated with security in case of G.

Conclusion

Beta value is a number to measure systematic risk associated with the stock. It is also useful to compare a risk between two stocks. It is always advised to consider beta value in one’s evaluation of stock prior to making any investment decision.

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