Beta or What Is Beta and How Is

Beta or…. “What Is Beta and How Is It Calculated? ”

Beta n A “coefficient measuring a stock’s relative volatility” n Beta measures a stock’s sensitivity to overall market movements Source: UBS Warburg Dictionary of Finance and Investment Terms

n In practice, Beta is measured by comparing changes in a stock price to changes in the value of the S&P 500 index over a given time period n The S&P 500 index has a beta of 1

A Generic Example n Stock XYZ has a beta of 2 n The S&P 500 index increases in value by 10% n The price of XYZ is expected to increase 20% over the same time period

Beta can be Negative n Stock XYZ has a beta of – 2 n The S&P 500 index INCREASES in value by 10% n The price of XYZ is expected to DECREASE 20% over the same time period

n If the beta of XYZ is 1. 5 … n And the S&P increases in value by 10% n The price of XYZ is expected to increase 15%

n A beta of 0 indicates that changes in the market index cannot be used to predict changes in the price of the stock n The company’s stock price has no correlation to movments in the market index

Company Beta AMGN BRK. B C XOM MSFT MWD NOK PXLW TXN VIA. B 0. 82 0. 73 1. 37 0. 10 1. 80 2. 19 2. 05 1. 93 1. 70 1. 39 Source: taken from yahoo. finance. com, except PXLW from

Beta and Risk n Beta is a measure of volatility n Volatility is associated with risk

Risk-Reward Curve Risk Expected Return

n If beta is a measure of risk, then investors who hold stocks with higher betas should expect a higher return for taking on that risk n What does this remind you of?

Beta and CAPM The capital asset pricing model: E(R) = Rf + B(Rm-Rf) where: E(R) = Expected return Rf = risk free rate of return B = beta Rm = market return

WACC Weighted average cost of capital: WACC = (D/V)*Rd*(1 -T) + (E/V)*Re where: D = market value of firm’s debt Rd = return on debt securities T = tax rate E = market value of firm’s equity securities Re = return on equity securities (from CAPM) V = total value of firm’s securities (D + V)

WACC and Beta WACC increases as the beta and the rate of return on the equity securities increases (all else constant) n WACC is used as the discount rate in DCF models n Therefore, increasing WACC reduces the firms valuation to reflect the increase in risk n

How to Calculate Beta = Covariance(stock price, market index) Variance(market index) **When calculating, you must compare the percent change in the stock price to the percent change in the market index**

How to Calculate Beta Easily calculated using Excel and Yahoo! Finance n Use COVAR and VARP worksheet functions n An example: Calculate the beta of Citigroup stock over the 5 -yr time period from Jan. 1, 1997 – Dec. 31, 2001 n

S&P 500 Adjusted Daily Closing Values: January 1, 1997 December 31, 1997 Citigroup Adjusted Daily Closing Prices: January 1, 1997 December 31, 1997