Today while reading a magazine, I have found the term ‘stock beta’ in various pages. I thought I will share the term ‘beta’ with blog readers to clear any doubts and get some better knowledge on the term.
We are generally hearing the term ‘stock beta’. But most of us doesn’t have knowledge about what it mean and why an investor need to consider the stock beta value at the time of investing a stock?Beta value a stock is nothing but it shows the relation of a stock or group of stocks to its index. Statistical calculations and formulas using to identify the exact beta value of a stock. Knowing the beta value of a stock will give you better idea on the volatility side of a stock against its index. Investor can identify the beta value of a sector, that is a group of stocks, to even know the volatility of the sector or stocks in that sector against the index.For an example, if a stock names ABC has a beta value of 1.4 means that when the index coming down to 10%, the stock price of ABC will come down to 14%. Thus is the beta value of a stock named ZYX has 0.6, means that when the index coming down to 10%, price of the ZYX come down to only .60%. An investor always keep in mind that, the beta value always calculating against the index to which the stock belongs too.It is always a good idea to buy stocks that have low beta value than high. If it shows low, the volatility will be low and it give some kind of security to the investor. Generally well established large cap companies some time known as heavy weight companies, have low beta value. Fast booming sector stocks like real estate stocks, commodity or IT stock generally have big beta value and that is the reason the stock declining a considerable percentage against the index. As I said earlier, statistical calculations used to identify exact beta of a stock. Keep in mind that, beta is a term mostly used and misused because of the difficulty to calculate to the exact numbers. A simple, practical method widely using to calculate the beta value is, dividing the company return rate with its index return rate. For an example, if an index expected to give 15.8% return this year and a stock in that index expected 12.7% return. The beta of this stock will be 12.7/15.8 = .8Here is an another method to calculate beta of a stock considering its return at the time of bear and bull phases.
Suppose a stock named ABC generating returns as per below:
ECONOMY — Market Return% — ABC expected returnbear ———- 2.50 ————– 3.40bull ———- 16.3 ————– 12.8
Here one can calculate the beta of ABC using the below formula:
Variables definition:E(R)_bull = expected return on ABC in a bull market E(R)_bear = expected return on ABC in a bear marketRM_bull = return on the market portfolio in a bull marketRM_bear = return on the market portfolio in a bear marketBy definition the Beta of a security is the slope of its Security Characteristic Line (SCL), which is a plot of return on a security as a function of the return on the market.The slope of the Security Characteristic Line (SCL) of ABC’s stock is:BETA = (E(R)_bull – E(R)_bear) / (RM_bull – RM_bear) = = (12.80 – 3.40) / (16.30 – 2.50) = = 0.68116The Beta of the ABC’s stock is 0.68.Hope you have understood the idea well. Feel free to comment here to know any more clarification on this.