Beta Analysis: How useful it is for stock selection?
Investors look at several parameters like EPS, earning growth rate, ROIC, Debt-to-profit, P-E ratios and many more of a company to find a good buy. These parameters are no doubt will get us to the best companies available at a point of time. But there are some other important parameters which can enhance our return when looked properly. Stock’s Beta is one such parameter, which is easy to calculate and easy to apply while selecting stocks.
Volatility and Risk:
When we analyse stock prices, we can notice two types of volatility. The first type can be attributed to the company-related factors such as delay in projects, concern about growth potential, competition from within and outside the country, Industry structure and changes in the management and financing patterns. Risks generated due to these factors are usually industry-specific and called ‘unsystematic risk’. According to Portfolio theory the overall unsystematic risk can be reduced by adding other scrips that have a different element of risk.
The other type of risk is ‘systematic risk’. Due to this risk the stock’s movement becomes dependent on the overall market movements. Apart from being affected by the factors like big events (Budget, RBI monetary policy, rise or fall in IIP etc.), stock market gets sharp fluctuations time to time. This is usually is known as “market sentiment”, which pushes stock prices up and down from time to time. The degree of fluctuation in each stock’s price will depend on each stock’s relationship with the overall market. Some stocks move in tandem with the market, some move more than proportionately on the same side of the market, and others inversely.
Beta Calculation and Analysis:
Though there are various ways of monitoring these volatilities like technical charts, stocks beta is perhaps the most important measure of stock risk, volatility and a the extent of the stock’s association with market. Beta analysis can provide great insights into the movements of a particular stock relative to market movements.
The concept of beta is actually very simple – it’s a measure of individual stock risk relative to the overall stock market risk. It’s sometimes referred to as financial elasticity. It’s just one of several values that we can use to get a better feel for a stock’s risk profile. Before investing in a company’s stock, the beta analysis allows an investor to understand if the price of that security has been more or less volatile than the market itself. Taking decision based on a sound beta analysis will definitely enhance the portfolio performance.
Generally beta of companies is given by various reports published by investment firms. But calculation of beta can also be easily done and is very straight forward.
To calculate a stock’s beta we only need two sets of data, first, closing stock prices for the stock we are examining and closing prices for the index chosen as a proxy for the stock market. It can be BSE 500 or Sensex.
The formula for the beta can be written as:
These, Covariance and variances can be easily calculated by the use of MS Excel.
The interpretation of Beta values is also easy. In simple words, if the stock’s price experiences movements greater (more volatile) than the stock market, then the beta value will be greater than 1. If a stock’s price movements are less than the market fluctuations then the beta value will be less than 1. And if the stock price is moving along with the market movement then the beta will be near about 1. Since beta also represents risk factor then a beta value higher than 1 will indicate more risk and in turn more expected return for investors (similar to more risk more gain funda!!!) The reverse is also true of a stock’s beta is less than 1, in that case we’d expect less volatility, lower risk, and therefore lower overall returns.
Companies’ growth opportunities are a very important determinant of their beta value. Generally firms with more growth opportunities tend to have higher betas. Since the expected growth is also associated with uncertainty and risk. For example, a firm’s growth opportunities usually depend on the new project, product development and expansion plan. But even decisions about these plans depend on information about cash flows upon project completion which has a systematic risk component. Empirically the link between a firm’s future growth opportunities and its beta has been established by various researches.
How to use Beta?
How we use beta for investment in stocks is very much dependent on our risk appetite. Like I said, beta measures a stock’s association with market movements and represents volatility and thus risk associated with that stock.
Choosing company which has beta more than 1 means we are selecting more volatile stock. For example, an early-stage technology company’s stock will have a beta greater than 1. This company’s stock price will bounce up and down more than the market. Definitely these kinds of companies will be riskier than, say; utility industry stocks which have low beta or beta close to 1. Of course, here risk also implies return. Stocks with a high beta usually give a higher return than the market.
A risk-averse investor may like to look for companies which have beta 1 or very close to 1. Generally most blue chip companies have beta close to 1 or lower than 1. And because of this these companies are considered as safe bets in a volatile market.
There are some obvious flaws of beta value. One of them is, Beta value of a stock is dependent on historical price movements and history is not always an accurate predictor of the future. Second problem with beta is that it doesn’t account for changes that are in the works, such as new lines of business or heavy debt taken by a company. These issues get reflected only after some time.
The third and I think most important problem with beta is that it does not include any sudden fall in price of a stock (for some sudden development). For example a company which has a very high beta (say 1.5) will be termed as a risky bet. Now suppose its price starts falling (say, due to heavy sell out by FIIs). For any value investor this huge fall in prices will be an opportunities whereas beta will still term as a risky bet despite the fact that here risk factor has come down due to fall in prices.
Though, looking at beta before investing in a stock is a good practice but looking only at beta and ignoring fundamentals can lead to a bad portfolio performance. Beta can never be a substitute to the fundamental analysis. Instead beta can be used as a add on tools to take a more informed decisions.
So I hope next time when you look for companies financial health, you will also try to look at the stock’s beta before taking any decision.