Question

In 300 words. Discuss beta and its components

Answer 1

Beta : Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.

Beta is a key component for the capital asset pricing model (CAPM), which is used to calculate the cost of equity. Recall that the cost of capital represents the discount rate used to arrive at the present value of a company's future cash flows. All things being equal, the higher a company's beta is, the higher its cost of capital discount rate. The higher the discount rate, the lower the present value placed on the company's future cash flows. In short, beta can impact a company's share valuation.

1. A theoretical characteristic of a stock or a portfolio of stocks, written ?, that is a measure of
sensitivity to movements of the stock market as a whole;
2. The estimate of that theoretical characteristic, to be calculated from actual data and assumed to
maintain its value in the future;
3. The result of multiplying definition 2) by the stock market’s return; this amounts to the portion of
the stock’s or the stock portfolio’s return that is attributable to its participation in the stock market;
4. A synonym for “the return of the stock market”; this is more qualitative than quantitative.
5. A synonym for “the risk of the stock market”; this is more qualitative than quantitative.
And two more, which I haven’t yet touched upon:
1. The portion of a stock’s or a stock portfolio’s return that is attributable to its exposure to all of the
common economic factors that may drive its returns, not just the stock market return alone. This
is like definition 3), but more expansive, and also more qualitative.
2. The sensitivity of one thing to a change in another thing. This tends to be more qualitative than
quantitative. I will say no more about it here.
Investment analysts work with actual values calculated according to definitions 2) and 3), but not the
others. From here on, I when I write “beta,” I will mean definition 2), which is the one I presented at the
outset, or definition 3); these seem to be the most commonly used.