What is a beta and what does it measure?

A beta is a measure of relative risk, with the risk defined as exposure to macro economic variables (interest rates, overall economic growth, inflation). Thus, a stock with a beta of 1.2 is 1.2 times more exposed to macro-economic risk than the average stock in the market.

Technically, a beta measures the risk added by an investment to a well diversified portfolio.

Beta only measures only macro-economic risk exposure of a company and not firm specific risk. (CAPM assumes that you have a diversified portfolio). If you do not want to play the diversification game, then you need to come up with a different risk measure altogether which measures firm-specific risk as well.


Can betas be negative?

Yes. Any investment that, when added to a portfolio, makes the overall risk of the portfolio go down, has a negative beta. It is akin to buying insurance against some macro-economic risk that affects the rest of your portfolio adversely.

A standard example that is offered for a negative beta investment is gold, which acts as a hedge against higher inflation (which devastates financial investments such as stocks and bonds). It is also true that puts on stocks and selling forward contracts against indices will have negative betas.

The consequences of a negative beta are that the expected return on that investment will be less than the risk free rate.


What are the ways of estimating beta?

According to Prof. Aswath Damodaran, there are two types of betas:

  • Historical Betas: These are calculated as the regression of the stock price of the company and an index.
  • Fundamental Betas: It can be argued that risk is determined on the basis of what the company does. Companies don’t have betas but businesses do have betas. So a company involved in different businesses is going to have different betas for each business.
    • Nature of product or service offered by the company: Industry effects: The beta value of a firm depends upon the sensitivity of the demand for its products and services and of its costs to macroeconomic factors that affect the overall market.
      • Cyclical companies have higher betas than non-cyclical companies.
      • Firms which sell more discretionary products will have higher betas than firms that sell less discretionary products.
      • Sometimes a particular product or service may be non-discretionary in one market but may be discretionary in other markets (for instance telephone services in developed markets and in emerging markets). Accordingly, while determining a beta, we should also consider country analysis since telecom companies in developed markets are going to have lower beta compared to telecom companies in emerging markets.
    • Operating leverage effects (cost structure of the company): Operating leverage refers to the proportion of the total costs of the firm that are fixed costs. Other things remaining the same, higher the operating leverage, greater is the variability in earnings which in turn results in higher betas. (industries with higher proportion of fixed costs – airlines, steel, infrastructure, etc.)
    • Financial Leverage (creating fixed costs you do not have, until you borrow money): Other things remaining the same, higher the proportion of debt in a company’s capital structure, greater is the variability in earnings which in turn results in higher betas.