What Are Stock Beta Values?
The beta value is a measure of individual stock's risk compared with the overall stock market risk. In other words, the higher the beta, the higher the risk.
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Defining Beta Values
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The beta value of a stock is calculated using historical prices and comparing the volatility of the stock price to the volatility of the stock market, using a market volatility index of 1.
• Negative beta (a rarity) - the stock price moves the opposite of the market.
• Zero beta (a rarity) - the stock price isn't changing, no matter where the market is moving.
• Beta between 0 and 1 - the stock price is less volatile than the market.
• Beta of 1 - the stock price is moving with the market and in the same direction.
• Beta greater than 1 - the stock price is fluctuating more than the market.
Interpreting Beta Values
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• Beta values between 0 and 1 - Blue chip stocks typically have beta values between 0 and 1, indicating low-risk, low-return stocks.
• Beta values greater than 1 - Growth and technology companies usually have beta values in this range and fall into the high-return, high-risk class.
• Beta values much greater than 1 --These high values can be indicative of high price volatility because the stock isn't selling well. -
Predicting Return Based on Beta Values
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Using the Capital Asset Pricing Model (CAPM), you can calculate the expected rate of return on an investment using the formula: Expected Rate of Return = r = rf + ß (rm - rf) where
• rf = the risk-free interest rate that an investor would expect to receive from a risk-free investment, for example, US treasury bills.
• ß = the beta value for that particular stock.
• rm = the market return the investor would expect to receive according to a large stock market indicator such as the S&P 500.
Advantages of Beta Values
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Beta values are important measures of stock risk and are relatively easy to interpret. The calculation of beta values is based on the sound financial CAPM.
Disadvantages of Beta Values
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A beta value does not tell you what the price of a stock is going to be in the future, nor does it distinguish between large upswings or downswings in the market. The beta value does not predict how a stock will perform in a bull market or a bear market.
Warning
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Beta values are based on past performance. Beta values are not necessarily predictors of what a stock or the stock market is going. You should always consider market volatility and the time period during which the beta value was measured before making an investment decision.
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References
- Photo Credit Image by Flickr.com, courtesy of Balazs Gal
