Beta - A Measure of Market Risk

 

Friends Let’s Learn about Beta.

1.    What is Beta

Simply we can say that Beta is a Relative Risk Measure of Riskiness of a business in Relation to Market.

Beta tells that how much a stock is risky as compare to the market. Market’s Beta is always 1 Then is any company’s beta is more than 1 then it means that company is riskier than market and if it is less than 1 then it means the company is less risky than market.

Beta tells that how much a stock moves compared to the overall Market.

2.    Simple Example

Market means Market Index Like Nifty 50 or Sensex, now as mentioned Nifty 50 or Sensex Beta is 1

Case 1. If any company’s Beta is 1.5 than if market goes 10% up than stock goes up 15% (more risky, moves faster)

Case 2. If any company’s Beta is 0.5 than if market goes 10% up than stock goes up 5% (less risky, moves slower)

Case 3. If any company’s Beta is negative means if market will go up than stock will go down. Stock actions opposite to market (like gold or hedging assets).

3.    Why Beta is Important?

CAPM model – Beta is used in CAPM model to calculate Expected return of a stock (Ke = Cost of Equity)

Investors – Beta helps investors to take decision if the stock is risky or safe for investing purpose.

Portfolio Management – Beta is useful to analyse the risk and balance or diversify the risk.

4.    Beta calculation methods

A)     Historical Beta Calculation (Most Common) - Collect past returns of stock and past returns of market index (like Sensex or Nifty 50). And use the below formula using MS Excel (covariance ÷ variance).

            ​Covariance → How stock and market move together.

Variance → How much the market itself moves.

B)     Regression Method (Line Slope Method)

·       Plot stock returns (Y-axis) vs market returns (X-axis).

·       Draw a line of best fit (regression line).

·       The slope of the line = Beta.

·       This is what Bloomberg, Money control, Yahoo Finance use.

C)     Bottom-up Beta (for new companies / private firms)

 

·       If company is start up or a new company and it is not listed in stock market then we take industry Beta.

·       Adjust it with company’s debt and equity (because risk changes due to leverage changes).

Formula used: 

Unlevered Beta = Industry Beta ÷ (1 + (Debt/Equity))

Levered Beta = Unlevered Beta × (1 + (Debt/Equity of company)

 

D)     Proxy Method (Quick Estimate)

If detailed data is not available, use similar company’s Beta as proxy.

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Weighted Average Cost of Capital (WACC)

 

1. Meaning of WACC

When any company raise any money from market through equity shares, preference shares and debt. Company pays dividend or interest for using their money. Weighted average cost of capital is the average rate of this dividend or interest rate according to weight of equity, preference and debt.

In simple words this average rate is the minimum return which company need to earn for satisfy investors and lenders.

2. Formula

Where:

 

E = Current Market value of Equity

V = Total value (Equity shares + Debt + Preference shares)

D = Current Market value of Debt

P = Current Market value of Preference shares (if any)

Re = Cost of Equity (Ke)

Rd = Cost of Debt

Rp = Cost of Preference shares

Tc = Corporate Tax Rate

 

3. Components

A) How to calculate Cost of Equity (Re)

Most commonly calculated using CAPM model:

Re=Rf+β(Rm−Rf) 

Rf = Risk-free rate (e.g., Govt. bonds)

β (Beta) = Company’s systematic risk

(Rm - Rf) = Market risk premium

Link - Capital Asset Pricing Model

 

B) How to calculate Cost of Debt (Rd)  ​

Since interest is tax deductible, we take after-tax cost = Rd×(1−Tc).

 

C) How to calculate Cost of Preference Shares (Rp)

Rp = 

4. Use of WACC

o   Used as discount rate in DCF (valuation)

o   Helps in capital budgeting decisions (project should earn > WACC)

o   Measures cost of financing and risk

5. 𝗪𝗵𝘆 𝗶𝘀 𝗪𝗔𝗖𝗖 𝗶𝗺𝗽𝗼𝗿𝘁𝗮𝗻𝘁?

o   Helps companies make informed decisions about investments and funding

o   Provides a benchmark for evaluating project returns

o   Essential for determining a company's optimal capital structure

         6. Conclusion

Calculating WACC is an essential skill for finance professionals, and it can help companies make informed decisions about investments and funding. I hope these notes are helpful! Let me know if you have any questions or if you'd like to discuss further.

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​

Capital Asset Pricing Model (CAMP)

 

Who & when developed this model –

The CAPM model was given by 3 Economist in 1960.

1.      William F. Sharpe (1964) – Most of credit goes to William F. Sharpe for developing CAPM model, He later awarded by the Nobel Prize in Economics (1990) for his work on CAPM.

2.      John Lintner (1965)

3.      Jan Mossin (1966)

They extensive worked on Harry Markowitz’s Modern Portfolio Theory (1952), which clarified diversification and well-organized portfolios, in this model we talk about the linkage of expected return with Risk.

So, the main inventor credited = William Sharpe, but it’s actually a joint development with Lintner and Mossin.

Now Let’s understand What is Capital Asset Pricing Model (CAPM)

CAPM is a financial model by which we calculate the expected return on the equity invested in the market based on the company’s risk in relation with market risk.

The components of CAPM model

1.      Risk free rate – investor should be rewarded with Risk free rate for time value of money

2.      Equity risk premium & Beta - investor should rewarded with equity risk premium for extra risk taken by investing in the particular company’s equity.

 

Capital Asset Pricing Model (CAPM) Formula

E(Ri​)=Rf​+βi​(Rm​−Rf​)

here:

 E(Ri) =it is Expected return on the Equity (investment)

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Understanding Beta (β)

Beta (β) → Measures systematic risk (stock sensitivity to market).

·       β = 1 → same risk as market

·       β > 1 → riskier than market

·       β < 1 → less risky than market

·       β < 0 → moves opposite to market

 

Example

Risk-free rate = 5%

Market return = 12%

Beta of stock = 1.2

E(Ri​)=Rf​+βi​(Rm​−Rf​)

E(Ri​)=6%+1.1(11%-6%)

         = 5% + 5.5% = 10.5%

This means investor should expect 10.5% return from this stock.

Assumptions of CAPM

·       This model is for the Investors who are risk-averse.

·       Unlimited borrowing/lending at risk-free rate.

·       In this model No consideration of taxes, no transaction costs (brokerage).

·       It assumes that all investors have same expectations for market and equity shares.

·       It also assumes that Markets are seamlessly efficient.

·       Returns are normally distributed.

These assumptions are unrealistic but make the model simple.

 

Advantages

·       It is Easy to use, only one simple formula.

·       Generally accepted in valuation, corporate finance, and portfolio theory.

·       It is very useful for calculating cost of equity (important in Weighted average cost of capital, Discounted cash flow method)

·       Connects risk - expected return directly.

 

Disadvantages

·     Impractical assumptions – practically tax we pay, risk free borrowing in not practical. This model doesn’t consider both tax and risk on borrowing.

·       Beta is not steady; it keeps changing over time.

·       Market return estimation depends on person to person.

·       It Doesn’t consider unsystematic risk.

·       Can give misleading results in inefficient markets.

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$$

Risk free Rate

 

Let’s learn about the simplest topic – Risk free rate, students read that risk free is Bank FD rate or govt bond rate. However, that’s not correct.

Here today we will learn, what is risk free rate, why we use it, where we use it, what books says about risk free rate, what is best practices in corporates, corporate reality vs Theory in the books, Myths About Risk-Free Rate

Let’s start with what is risk free rate.

The risk-free rate is the Return on investment when any investor invests with zero risk of non-payment & most certainty of ROI & capital invested.

Eye opener for investors – there is nothing like risk free investment in the world, now people say any bank FD rate is safe, secured & risk free by Reserve bank of India. However, the risk is still there. Also, people believe that govt bonds are risk free but the risk is still there. So, nothing is risk free.  

it is myth that Government bonds are truly risk-free. Inflation, political, or currency risks remain. “Risk-free” is relative, not absolute.

What are academic books say: -

Damodaran (Valuation guru) - Mr. Ashwath Damodaran says risk free rate should be without default risk and no reinvestment risk.

Corporate Finance books – Government bonds are closest proxies for risk free rate. And generally, school and college teachers and professors teach that take bank FD rate or 10 year’s government bond rates as a risk-free rate.

Best Practice in Corporates

Currency match with valuation: while doing valuation, the cash flows and government bond yield (10 Year) should be in same currency for example: if cash flows are in USD then government bond yield INR then convert either cash flows in INR or convert government bond yield in USD

Match time horizon of cash flow and project maturity: For long-term projects, use long-term bond yields (10–30 year).

Adjust for country risk: If valuing any company in a country where the default risk is higher, add a sovereign risk premium. For example, currently Russia Ukraine war is going on than Russia and Ukrainian companies have some extra risk.

Consistency: Risk free rate, Equity risk premium, & beta must be from the same market and currency.

Where we use Risk free rate:

Risk free rates are used to: -

CAPM model – for calculation of cost of equity there is a model CAPM model (capital asset pricing model). The formula of CAPM model is

                    Cost of Equity=Rf+β(Rm−Rf)

Rf = Risk free rate

β= Beta

Rm = Return on Market

DCF Valuation: - while doing valuation risk free rate is used to discount the cash flows.

WACC calculation: - As cost of equity is depends on Risk free rate, weighted average cost of capital is also depends on Rf.

Baseline benchmark: - Pension funds, insurance companies use Risk free rate as baseline standard. Also, it is used to project financial models.

Smart Analysts do for risk free rate (Best Practices)

ü  Match currency of Risk-free rate and cash flows.

ü  Match maturity of Rf and project horizon.

ü  If country has sovereign risk, then adjust properly.

ü  Use current yield curve, not averages.

ü  Use Rf, ERP, and beta consistent.

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