Financial Modeling Self Study Program

What is Beta?

Beta is a measure of the riskiness of a stock relative to the broader market (for broader market, think S&P500, Wilshire 5000, etc).  By definition the “market” has a Beta of one (1.0).  So a stock with a Beta above 1 is perceived to be more risky than the market and a stock with a Beta of less than 1 is perceived to be less risky.  For example, if the market is expected to outperform the risk-free rate by 10%, a stock with a Beta of 1.1 will be expected to outperform by 11% while a stock with a Beta of 0.9 will be expected to outperform by 9%.  A stock with a Beta of -1.0 would be expected to underperform the risk-free rate by 10%.  Beta is used in the capital asset pricing model (CAPM) for the purpose of calculating a company’s cost of equity.  For those few of you that remember your statistics and like precision, Beta is calculated as the covariance between a stock’s return and the market return divided by the variance of the market return.

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