Finance – Three factors that determine Beta Values

What is Beta in Finance?

The beta (β) of a stock or any other investment security is a calculation of its volatility of returns in comparison to the entire market. It is utilized as a calculation of risk and is an important part of the Capital Asset Pricing Model (CAPM). A stock with a greater beta has greater risk as well as greater expected returns.

The beta coefficient can be understood as follows −

• β = 1 − Beta exactly as volatile as the market
• β < 1 − Beta is less volatile than the market
• β > 1 − Beta is more volatile than the market
• β = 0 − Beta is uncorrelated to the market
• β < 0 − Beta is negatively correlated to the market

Examples of beta

• High β – A company with a β greater than 1 is more volatile than the chosen market. For example, a high-risk electronic company with a β of 1.65 would have returned 165% of what the market has returned in a given period.
• Low β – A company with a β lower than 1 is less volatile than the entire market. As an example, if an energy supplier company with a β of 0.35, which would have returned only 35% of what the market has returned in a given period.
• Negative β – A negative β company is negatively correlated to the returns of the market. For example, a jewelry company with a β of −0.3, which would have returned −3% when the market was up 20%.

Three factors that affect Beta values

• Nature of the business. Usually, the earnings of a company keep on fluctuating with time due to the business cycles. The earning may go up in the growth phase in the business cycle, while the earnings may go down when a firm is in the contraction phase. Therefore, the company's earnings are related to the conditions of business. In such circumstances, the accounting betas usually correlate with the market beta, which is based on share market returns and not the earnings.
• Financial leverage. Financial leverage is described as the debt portion of the financial structure of a company. It shows how much debt a company has taken to run the business. The more the debt, the greater is the risk of the business organization. So, growth in financial leverage increases the financial risk. Therefore, this will increase the beta of a companies’ stock as well.
• Operating leverage. Operating leverage is the change in economic earnings before tax and interest. Having operating leverage makes the companies be more volatile in terms of management of assets. Firms with a higher operating lease are risky; consequently, their stocks have a higher beta.