The beta coefficient measures differences between the return on a stock and the average market return. It is used to determine the risk of a particular stock and to help calculate the expected rate of return. It is one of the main factors used to pick a particular stock for an investment portfolio as well as other factors like debt to equity ratio, price to earnings ratio and more.
Beta Coefficient Formula
β = Return premium for the individual stock / Return premium for the stock market
In the example above, β would simply be 7 / 5 = 1.4
When β > 1, it suggests that the stock is more stable than the whole stock market.
When β < 1, it suggests that the stock is less stable than the whole stock market.
If β < 0, it suggests that the stock will lose money as the market gains. It could also mean that the stock market as a whole is losing money while the stock is gaining in value, but this is less likely. A negative β is usually due to the fact that the individual stock’s return premium is negative, not the stock market.
Beta Coefficient Video Tutorial With Examples
Calculating Beta Coefficient
The beta coefficient of a stock can be calculated with a basic equation. The first step is to find the risk free rate, which is the rate of return that can be expected on a particular investment when there is no money at risk. It is usually demonstrated as a percentage, for instance 1% or 2%. The risk free rate can be found by looking at the rate for 10 year United States treasury bonds.
The next step is to find the expected rate of return for the individual stock and the stock market (index). The rate of return estimation for both the stock and the stock market (index) should be calculated over several months or several years in most cases. The values may be positive or negative.
Beta Coefficient Formula Video Example 1
Beta Coefficient Formula Video Example 2
The expected rate of return for the stock market should be determined for the market in which the individual stock is trading. For example, in the United States the S&P 500 index is normally used as the expected rate of return for the stock market. In Europe the MSCI EAFE would be used, and other foreign markets would have their own indexes.
After you have the expected rate of return for both the stock and the stock market as a whole, you would subtract the risk-free rate of return from the individual stock’s rate of return to find the return premium for the stock.
For instance, if the individual stock’s estimated rate of return is 9%, the formula would be 9% (individual stock’s rate of return) – 2% (risk free rate of return) = 7% (return premium for the individual stock).
Then you would subtract the risk-free rate from the stock market (index). If the calculated rate of return for the stock market was 7%, the formula would be 7% (stock market rate of return) – 2% (risk free rate of return) = 5% (return premium for the stock market).
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