Beta Values for Risk Estimation

Dr.M. Sharmeen Farooq

Senior Assistant Professor
Ethiraj College for Women
Chennai

ABSTRACT
One of the most important measures of stock risk or volatility is a stock's beta. The
investor or an analyst generally looks at a stock's beta before making a purchase decision. It
is a one glance measure that provides stock analysts and investors with an insight on whether
the price of that security has been more or less volatile than the market, which is a good
variable to comprehend before adding any security to a portfolio. This is an important step to
take as part of any robust stock research effort.

The article is an attempt to define the concept of beta, the theory upon which it is
based, the computation of the measure and an insight into the correct use of beta values in the
analysis of a stock. It also explicitly gives a practical explanation on the calculation of beta,
as well as a link to a spreadsheet that can be used to calculate these values. The outcome of
this paper is to create an overall understanding of how to use this measure in practice.

KEY WORDS
Beta, Alpha, market index

INTRODUCTION
Beta measures the systematic risk of the company. The measure is one of several values that
stock analysts use to get a better feel for a stock's risk profile. It is also sometimes referred to
as financial elasticity. The beta value is calculated using price movements of the stock which
is analysed. The movements are then compared to the movements of an overall market
indicator, such as a market index, over the same period of time.
Beta values are easy to interpret. If the stock's price experiences movements that are
greater and more volatile than the stock market, then the beta value will be greater than 1. If a
stock's price movements, are less than those of the market, then the beta value will be less
than 1. An increased volatility of stock price means more risk to the investor, its reasonable
expecting greater returns from stocks with betas over 1. The reverse is true if a stock's beta is
less than 1; expect less volatility, lower risk, and therefore lower overall returns.
CAPM THEORY AND BETA
The Capital Asset Pricing Model explains the relationship between risk and expected return.
The risk premium equals to the beta of security times a risk premium of the security.
(Kuerschner, 2008). Stock beta values are a key element when using the CAPM. According
to the CAPM, the risk free rate and the market risk premium was the same for all companies,
it is only beta that is different for each company (Koller et. al, 2005) the CAPM is developed
as a method to evaluate market risk (Mukherji, 2011; Hillier et al., 2008). For example, by
using the following CAPM formula we can calculate the expected rate of return on an
investment as:
Expected Rate of Return = r = rf + B (rm - rf)
Where:
 rf = The risk-free interest rate
 B = A stock beta
 rm = The expected market return is the return the investor would expect to receive from
a broad stock market index. In the current study it is the BSE SENSEX

Translating this CAPM formula into words:

"The expected return on an investment is equal to the return on a risk-free investment plus
the risk premium that's associated with the stock market itself, adjusted for the relative risk of
the common stock chosen."

REVIEW OF LITERATURE
Academic literature suggests that there are beta is useful for the risk estimation and returns of
firms. The following literature provides evidence of the relationship between the calculated
beta of stocks and returns from the stock.
Fama and French (1992) examined the relationship between betas and returns
between 1963 and 1990 and concluded that there was no relationship. These results had been
contested on three fronts. First, Amihud, Christensen, and Mendelson (1992) used the same
data, performed different statistical tests, and showed that differences in betas explained the
differences in returns during the time period. Second, Kothari and Shanken (1995) estimated
betas using annual data and inferred that betas explained a significant proportion of the
differences in returns across investments. Third, Chan and Lakonishok (2001) studied a
longer time series of returns from 1926 to 1991 and established a positive relationship
between betas and returns in the period after 1982. They found that betas were a useful guide
to risk in extreme market conditions, with the riskiest firms (the 10 percent with highest
betas) performing far worse than the market as a whole in the 10 worst months for the market
between 1926 and 1991.

OBJECTIVES OF THE STUDY

The following are described as the objectives of the study:
1. To measure the beta value of shares of the selected companies using the spreadsheet
program and also estimate alpha arising from the implementation the same with the
use of the market index SENSEX.
2. To evaluate the beta value as a risk and performance measure of the firm.
3. To discriminate the domestic and multinational companies in terms of its expected
returns with the use of beta values.

METHODOLOGY
Beta calculated values are easily available on several databases and websites but the study
itself estimates beta values using data for a twelve month period. Share price data from the
website [Link] and market index values of BSE SENSEX from the BSE website
had been used in fairly straightforward linear regression technique which is the most
preferred approach. Thus beta is computed with the help of a spreadsheet application [Link]
developed by Professor Aswath Damodaran, Stern School of Business, New York which also
gives the various statistics for risk and performance assessment. To calculate a stock's beta
the data needed includes:
 Closing month-end stock prices for the stock being examined.
 Closing month end prices for the index (BSE SENSEX Index) being chosen as a proxy
for the stock market.
 Dividend information
The formula for this metric can be written as:
Beta = Covariance (stock versus market returns) / Variance of the Stock Market

ALPHA VALUES
The spreadsheet also includes the calculation of alpha values, which is a measure of excess
returns on an investment, adjusted for risk. This is a commonly used to assess the
performance of a portfolio manager as it's an indicator of their ability to provide returns in
excess of a benchmark such as the BSE SENSEX Index. For example:If alpha < risk-free
investment return, then the firm has destroyed value; if alpha = risk-free investment return,
then the firm has neither created nor destroyed value; and if alpha > risk-free investment
return, then the firm has created value.

DATA COLLECTION

This study is based on secondary data with select multinational and domestic
companies which are listed in the Bombay Stock Exchange. Listing on exchange is a
prerequisite since the stock price information is required. The study has an inclusive sample
of thirty two companies from different industries pertinent for the growth of the economy such
as Paints and Varnishes, Pharmaceuticals, Food and Beverages, Automobiles, Computer
Software, Electrical Machinery, FMCG and Consumer Durables. As the study aims to draw
comparison between the multinational and domestic companies in India, two companies from
each of the above category of industries were chosen for the study.
The share prices and dividend information for a period of twelve months from 1 st
April 2015 to 31st March 2016 was collected from [Link]. The market
index values for BSE SENSEX were taken from [Link]. BSE SENSEX was
chosen because it is regarded as the pulse of the domestic stock market with thirty most
actively traded stocks representing the various industrial sectors of the Indian economy.
The results of the computation of beta and alpha values are depicted in the following table:

Table 1: Computed values of beta and Alpha as risk parameters

Intercept Intercept - Rf
(Alpha) Slope (Beta) Rf (1- Beta) (1-Beta)
Co1 0.007197439 0.474931728 0.002297929 0.00489951
Co 2 0.005457404 0.668504661 0.001450769 0.004006635
Co 3 0.009427177 0.443067564 0.002437381 0.006989796
Co 4 0.00140139 0.576351467 0.001854072 -0.000452682
Co 5 -0.006373355 1.360766827 -0.001578874 -0.004794481
Co 6 0.004204227 1.223857344 -0.000979698 0.005183925
Co 7 -0.008165635 0.24713168 0.003294882 -0.011460517
Co 8 0.034726502 1.939426212 -0.004111341 0.038837844
Co 9 0.038538007 2.161304054 -0.005082376 0.043620383
Co 10 -0.011616433 2.179526956 -0.005162127 -0.006454305
Co 11 -0.004383587 -0.133116105 0.004959013 -0.009342601
Co 12 -0.030448918 3.01559248 -0.008821117 -0.021627801
Co 13 -0.050154954 0.680520919 0.001398181 -0.051553135
Co 14 0.060746645 3.074525101 -0.009079032 0.069825677
Co 15 0.022261346 0.383796439 0.002696777 0.019564569
Co 16 -0.006737733 0.978004912 9.62602E-05 -0.006833993
Co 17 0.018347968 1.283404163 -0.001240301 0.019588269
Co 18 0.021954435 0.5179539 0.002109645 0.01984479
Co 19 0.030555253 2.26395283 -0.005531612 0.036086865
Co 20 -0.00743211 0.944895643 0.000241161 -0.007673271
 Intercept Intercept - Rf
(Alpha) Slope (Beta) Rf (1- Beta) (1-Beta)
Co 21 -0.00743211 0.944895643 0.000241161 -0.007673271
Co 22 -0.003551632 0.930708811 0.000303249 -0.003854881
Co 23 0.010635782 1.253778867 -0.001110648 0.01174643
Co 24 0.015551853 2.421912744 -0.006222914 0.021774767
Co 25 0.013201943 1.250466082 -0.001096149 0.014298092
Co 26 0.019188355 0.73718809 0.00115018 0.018038175
Co 27 0.000194073 0.673829457 0.001427465 -0.001233392
Co 28 -0.010862846 -3.56712675 0.01998775 -0.030850596
Co 29 -0.006565006 -1.353154561 0.010298437 -0.016863443
Co 30 0.023193005 1.91120719 -0.003987842 0.027180847
Co 31 0.001968375 1.699773933 -0.003062518 0.005030892
Co 32 0.006156181 1.03477669 -0.000152198 0.006308379

The regression model for calculating the beta is useful as it provides a means of
performance evaluation. If there is a regress of (R-Rf) on (Rm-Rf), then the intercept of the
regression, or the “alpha”, provides an estimate of the amount by which the stock or a portfolio
has beat the market after adjusting for the beta risk. The intercept of the regression will be equal
to [alpha + Rf(1 - beta)]. So alpha = intercept – Rf (1-beta). A positive alpha means that the
portfolio has outperformed the market. A negative alpha means that it has lagged behind
the market.
The companies that are found to have a negative alpha total 14 in number with nearly
60% poor performers in the MNC category. The industries in which two companies reveal
poorer performance than the market are Food & Beverage, Pharmaceutical ,Electrical
machinery and FMCG sectors. Out of these 14 companies which report a negative alpha, nine
are those with high betas over .90 which explicitly brings out the relationship between the
riskier stocks and poor performance stocks. Twelve stocks with high betas have produced
returns higher than the market while low betas have resulted in positive returns. Thus the
companies which high beta values can outperform or underperform in the market but those
with low beta values can be considered to be safe provide lower but positive returns. Three
stocks report negative betas which show that the stock moves in the opposite direction to
the SENSEX.

INVESTOR IMPLICATIONS
Volatility may be a blessing or a curse based on the investor’s reaction to it. Buying when
everyone else is buying (the price is high) and selling in a panic when everyone else is selling
(the price is low) makes volatility a curse. However if the investor anticipates volatility it is a
blessing. The key is to remain focused on buying investments with a margin of safety. That
means being disciplined in your approach to buying and selling. If you maintain a margin of
safety it persuades one to buy at a low price and sell when the price exceeds its value.
Purchasing a high beta stock for more that it is worth means that the risk of losing
your principal is very high (even greater than if you buy a low beta stock). The time to buy
any asset which has a high beta stock is when the price is well below its real value. The risk
is lower and your probability of a positive return is exponentially higher. Whether one is
buying high beta stocks or dividend stocks; patience is required as investments should be
made only when the price is less than the real value of the asset as this lowers risk
substantially. Real risk lies is losing your principal. If you have an investment that is worth
Rs.10,000 but only pay Rs.7,500 you have a 33% (Rs. 2,500 / Rs7,500) margin of safety.
When calculating any values using price movements over the past three years, it's
important to remember the "past performance is no guarantee of future returns" rule applies
to beta too. Value investing is important in conducting stock research that focuses on a
company's fundamentals and an understanding of financial ratios before investing in a stock

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