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Understanding beta

This step examines how understanding the values for beta can be useful for investment and risk management strategies.
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© SOAS University of London

This article considers various values for beta, and what they mean for investment and risk management strategies.

What is a beta?

A beta close to one means that the returns on the company stock tend to have variability similar to the market return.

If beta is greater than one, the returns on the company stock are more volatile than the market return. A company stock with beta greater than one is called an aggressive stock.

If beta is less than one, the returns on the company stock are less volatile than the market return. A company stock with beta less than one is called a defensive stock.

Beta is useful for risk management

Can you see how knowing the value of beta could be useful for risk management?

Suppose the wider stock market experiences an upward movement over a period of time. An aggressive stock would be expected to experience a relatively larger positive return than the market. A defensive stock would also experience a positive return, but it would be relatively smaller than the market return.

However, if the market experiences a downward adjustment, an aggressive stock would be expected to experience a relatively larger negative return than the market. A defensive stock would also experience a negative return, but it would be a less negative than the market return.

Estimating beta

There are various methods available to estimate beta. We can collect data on the returns of the company stock, and the returns on the market, and estimate the relationship between them using statistical methods.

Or, we could analyse the company in more detail, and compare the operating and financial performance of the company relative to other companies in the sector in which it operates, and relative to other sectors and the wider economy.

Values for beta are published by various sources. However, it is important to know how the estimates have been obtained before the beta values are used to inform risk management strategies.

Mondelez International and Tesla Inc.

Earlier in the week, we considered the share prices of Mondelez International, the American multinational food, drink and confectionary corporation; and Tesla Inc., the American company manufacturing electric cars and solar panels. Let us consider the beta for these two companies.

Using the statistical method, we have obtained daily data on a broad stock market index, the Standard & Poor’s 500. We calculated the daily return on the index, and estimated the relationship between the daily return on Mondelez stock and the market return, for the period 2010 onwards. Using this method the estimated value of beta for Mondelez is 0.75.

This would suggest Mondelez is a defensive stock.

Published values

Let’s see how this compares to some published values:

  • Nasdaq provides an estimated value of beta for Mondelez of 0.72 (as of October 2018).
  • Reuters has as an estimate of beta for Mondelez of 0.82.
  • finance.yahoo.com quotes a Mondelez beta of 0.55, so it is important to understand the methodology used to obtain estimates.
  • What about the beta of Tesla Inc.? Using the statistical method, we obtain an estimate of beta for Tesla of 1.29. This suggests Tesla is an aggressive stock. Is that consistent with your perception of this company?
  • Again, Nasdaq quotes a value for Tesla beta of 1.47.
  • Reuters quotes a Tesla beta of 1.04.
  • In contrast, finance.yahoo.com quotes a beta for Tesla of 0.84.

Mondelez and Tesla provide examples of a defensive stock and an aggressive stock (considering all of the estimates above).

© SOAS University of London
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