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How does the nature of business affect the beta of a company?
What is Beta of a Company?
The "beta" of a company is an indicator of how sensitive the stock prices of the company are to systematic risk. Systematic risks are usually measured by looking at the return on a "market portfolio," a portfolio that contains enough stocks and other investment securities. A market portfolio is diversified enough so that all the firm-specific risks are assumed to cancel each other out so that returns are affected only by systematic risks.
In other words, the Beta of a company’s stock is relevant to its nature of business, as systematic risks are related to the changes or risks related to the company’s financial components.
- When the systematic risks go up, the beta will go up too.
- Conversely, when the company’s stock goes through less systematic risk, the beta comes down automatically.
Interpretation of beta
A beta value of 1 shows that the company's stock goes up in accordance with the market. When the returns on the portfolio increase 1 percent, the price of the stock rises 1 percent.
- A beta value that is greater than 1 shows that the stock is more fluctuating to systematic risk in regard to the market as a whole.
- A beta value that is less than 1 indicates the stock is not quite sensitive to systematic risk.
- A beta near 0 means the stock is mostly insulated from systematic risk.
The beta values and their connection with the stock prices show that the nature of business affects beta prices well enough. The stock prices are directly related to the nature and type of business. So, when the business is performing well, the stock prices will go up taking the beta up along with it.
The nature of the business also affects beta in another way. In the market, it is often seen that the stock prices of certain industries go up in some specific periods. Therefore, we can say that the stocks of certain industries which deal in the same products or services go up at certain periods. The beta values too will follow the trend in general.
How beta is related to the nature of business
Beta is a critical component of CAPM which states that, with increasing income, the investors demand more returns from their investments. This is directly related to beta and the nature of business. For example,
- A company that deals in logistics may offer encouraging dividends from its profits to keep the investors happy, in which case the beta value will go up.
- Another company may want to keep the extra funds as retained earnings, keeping the beta value low, as the prices of shares remain low for being unpopular among investors.
The type of business and whether it is market-preferred is a relevant question when we deal with beta and the nature of businesses have a lot to do with it.
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