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Beta Coefficient Analysis | Simple Definition

How to Calculate Company's Stock Price Volatility

Beta Coefficient: Stock's Volatility

DEFINITION:

  • an indicator of a sensitivity, volatility (frequency of price change), systematic risk of an individual security or an investment portfolio to the movements in the market as a whole (to the benchmark)
  • used to understand whether the stock is moving in the same or opposite direction as the rest of the market; how volatile and risky a stock is compared to the to the overall market (to the benchmark)
  • used in the capital asset pricing model (CAPM), which describes the relationship between systematic risk of investing in a security and asset's expected return. Used to determine the cost of capital when calculating WACC %.

How to calculate:

Beta coefficient (β) = Covariance (Rа, Rm) / Variance (Rm)
Beta coefficient (β) = Covariance of Market Return with Stock Return / Variance of Market Return

WHERE:

  • Covariance is a measure of the linear relationship of two random variables. When calculating beta coefficient, covariance describes how changes in a particular stock's returns are related to the changes in the overall market's returns. Thus, our random variables are the following:
    Rа= the expected return on a particular stock a (аsset)
    Rm= the average expected rate of return on the market as a whole (benchmark)
  • The variance is a measure of variability from the average value, shows how spread out the distribution of a random variable is. It measures a difference between actual and expected results. In beta coefficient calculations, it measures how the market moves relative to its mean value.

RESULT INTERPRETATION:

  • β = 1:, the price of the security is moving with the market; the stock and the overall market have equal volatility and move in the same direction; there is no any additional risk to the portfolio, but such stock does not increase the likelihood that the portfolio will provide a higher return.
  • β < 1: the security is less volatile than the market; less risk, potentially lower returns.
  • β > 1: the security is more volatile than the market; riskier, potentially higher returns.
  • β > O: Positive β: the security's price is moving in the same direction as the market.
  • β < 0: Negative β: the security's price is moving in the opposite direction from the market.
  • β = 0: no correlation between a security return and the market return; typical for fixed income securities.

NOTE:

  • Beta coefficients vary across industries and companies.
  • Beta β calculation relies solely on past returns and does not take into account the new data that may change returns in the course of time.
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