How should investors assess risk in the stocks they buy or sell? As you can imagine, the concept of risk is hard to factor into stock analysis and valuation. Is there a rating – some sort of number, letter or phrase – that will do the trick?
One of the most popular indicators of risk is a statistical measure called beta. Analysts use this measure all the time to get a sense of stocks' risk profiles.
While beta does say something about price risk, it has its limits for investors looking for fundamental risk factors.
What is Beta?
Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.
Beta is a key component for the capital asset pricing model (CAPM), which is used to calculate the cost of equity. Recall that the cost of capital represents the discount rate used to arrive at the present value of a company's future cash flows. All things being equal, the higher a company's beta is, the higher its cost of capital discount rate. The higher the discount rate, the lower the present value placed on the company's future cash flows. In short, beta can impact a company's share valuation.
The Advantages of Beta
To followers of CAPM, beta is a useful measure. A stock's price variability is important to consider when assessing risk. If you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk.
Intuitively, it makes plenty of sense. Think of an early-stage technology stock with a price that bounces up and down more than the market. It's hard not to think that stock will be riskier than, say, a safe-haven utility industry stock with a low beta.
Besides, beta offers a clear, quantifiable measure that is easy to work with. Sure, there are variations on beta depending on things such as the market index used and the time period measured – but broadly speaking, the notion of beta is fairly straightforward. It's a convenient measure that can be used to calculate the costs of equity used in a valuation method that discounts cash flows.
The Disadvantages of Beta
If you are investing in a stock's fundamentals, beta has plenty of shortcomings.
For starters, beta doesn't incorporate new information. Consider a utility company: let's call it Company X. Company X has been considered a defensive stock with a low beta. When it entered the merchant energy business and assumed high debt levels, X's historic beta no longer captured the substantial risks the company took on. At the same time, many technology stocks are relatively new to the market and thus have insufficient price history to establish a reliable beta.
Another troubling factor is that past price movements are very poor predictors of the future. Betas are merely rear-view mirrors, reflecting very little of what lies ahead.
Furthermore, the beta measure on a single stock tends to flip around over time, which makes it unreliable. Granted, for traders looking to buy and sell stocks within short time periods, beta is a fairly good risk metric. However, for investors with long-term horizons, it's less useful.
Beta is calculated using regression analysis. Beta represents the tendency of a security's returns to respond to swings in the market. The formula for calculating beta is the covariance of the return of an asset with the return of the benchmark divided by the variance of the return of the benchmark over a certain period.
The well-worn definition of risk is the possibility of suffering a loss. Of course, when investors consider risk, they are thinking about the chance that the stock they buy will decrease in value. The trouble is that beta — as a proxy for risk — doesn't distinguish between upside and downside price movements. For most investors, downside movements are risk while upside ones mean opportunity. Beta doesn't help investors tell the difference. For most investors, that doesn't make much sense.
There is an interesting quote from Warren Buffett in regards to the academic community and its attitude towards value investing: "Well, it may be all right in practice, but it will never work in theory." Value investors scorn the idea of beta because it implies that a stock that has fallen sharply in value is more risky than it was before it fell. A value investor would argue that a company represents a lower-risk investment after it falls in value – investors can get the same stock at a lower price despite the rise in the stock's beta following its decline. Beta says nothing about the price paid for the stock in relation to its future cash flows.
If you are a fundamental investor, consider some practical recommendations offered by Benjamin Graham and his modern advocates. Try to spot well-run companies with a "margin of safety" – that is, an ability to withstand unpleasant surprises. Some elements of safety come from the balance sheet, like having a low ratio of debt-to-total capital. Some come from consistency of growth, in earnings or dividends. An important one comes from not overpaying. Stocks trading at low multiples of their earnings are safer than stocks at high multiples.
Ultimately, it's important for investors to make the distinction between short-term risk – where beta and price volatility are useful – and longer-term, fundamental risk, where big-picture risk factors are more telling. High betas may mean price volatility over the near term, but they don't always rule out long-term opportunities.