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Beta

 

What is beta?

Beta is a ratio that measures volatility of an investment in relation to the whole market. In other words, it shows how the price of stock was changing compared to the whole market. Theoretically, beta can be from negative to infinite, however, in reality most of stocks have beta from 0.5 to 2.0. For example, if beta of a stock is 2.0 it means that historically the stock price did change twice as much as the total market (some index). If beta of a stock is equal to 1.0 that would mean that returns of a stock are adequate to returns of the total market. While negative beta would mean that security is moving other direction than the market and that is equal to negative correlation

 

Formula


Beta = Covariance between the returns of investment and returns of the market / Variance of returns of the market 

 

(If you are not professional investor, the chances that you will succeed to calculate beta for the stock correctly by oneself are very low. However, you don’t need to do that, because some financial portals as Reuters do provide this ratio for larger stocks. Another choice is to use sector’s beta and apply it to your stock – you may find average betas for sectors in here).

 

Using in Practice

Beta is used a lot in investment management process, especially by professionals that use DCF valuation. DCF requires a discount rate which is calculated using capital asset pricing model (CAPM) and the beta is one of the main inputs in this model. 

 

Other investors also use beta as a risk measure of a stock. The practical problem is that betas have to be from one source and calculated by single methodology because if you will use betas from different source, they will be different even for the same stock

 

 






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