At this point, you may have come across a measurement known as beta. If you’re wondering what the beta of a company tells you about it, we have the answer.
What does the beta of a company tell us?
It is a Greek letter that takes on a unique meaning in the world of finance. Here, beta is a measure of volatility that is often used in financial comparisons. It helps to gauge a company’s movement with the overall market. The overall market beta is one – this is standard. Thus, a company’s beta will either be less than one, equal to one or greater than one. In the first case, a company with a beta less than one means it is less volatile than the market. A beta equal to one suggests a company that is just as volatile as the overall market. And finally, a beta greater than one suggests a company that is more volatile than the market. But what does this actually mean? In the next section we’ll discuss how a company’s beta reflects how it moves in tandem with the market.
Also note, the beta of a company tends to be higher for new companies, versus established incumbents in an industry like utilities companies.
In simpler terms, how does the beta affect a company’s relative movement to the market?
So the short answer is that it shows you the correlation between a specific company and the overall market. Basically, if the beta of a company is positive, then the company has a positive correlation with the overall market. This means that when the market is doing well and is on the rise, the values of these companies tend to be higher in terms of stock prices.
On the contrary, if a company has a negative beta, then it has a negative correlation with the overall market. This means that it acts in the opposite direction of the overall market. So if the market goes up, these company’s values as determined by stock prices typically go down or remain level. And vice versa if the market goes down, these companies go up. A couple of common examples of companies with negative beta values are dollar store chains and gold companies. Both of these can be used to hedge risk in your portfolio.
When and why is beta used?
Beta is a popular measure for volatility in the finance world. It’s looked so favorably upon as it tends to be easier to work with and offers a quantified value of volatility, otherwise known as risk.
It is used in financial valuation techniques like the Capital Asset Pricing Model method, which we will discuss further in an article to come. Essentially, this method is used to evaluate the returns on various assets. It uses a company’s beta to help determine the premium that should account for the added risk of investing in it.
It’s also used to in the calculation to determine the overall risk of a portfolio. Specifically, a series of betas and corresponding assets can help you to achieve a certain level of volatility in your portfolio as measured by beta.
And finally, beta is used to calculate the cost of equity (i.e. weighted average cost of capital - WACC) that public firms have access to.
Drawbacks of beta.
Beta is a backward looking measure that is based on historical data. Unfortunately, the measure doesn’t account for new data or have a future-oriented outlook. It can be risky relying on past data to indicate future performance. Other than that, beta is still used as a standard measurement in the world of finance.
The bottom line is that the term beta is very popular in the finance world, and you definitely need to know it too. Why wait when you can level the stock market playing field once you know what the professional traders know. Our Elite Legacy Education instructors will introduce you to the trading strategies that produce potential profit when stock prices are falling, lock in gains, reduce risk, and squeeze extra money out of stocks in your portfolio.
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