Stock Beta and Volatility

Perhaps the single most important measure of stock risk or volatility is a stock's beta. It's one of those at-a-glance measures that can provide serious stock analysts with insights into the movements of a particular stock relative to market movements.

In this article, we're going to first attempt to define the concept of beta values, including some of the theory upon which it's based. Next, we're going to talk about the pros and cons of the measure, while providing insights into the correct use of beta values when analysing a stock.

Beta Values
The concept of beta is fairly simple; it's a measure of individual stock risk relative to the overall risk of thestock market. It's sometimes referred to as financial elasticity. The measure is just one of several values that stock analysts use to get a better feel for a stock's risk profile. As we'll see later on in our discussion, the beta value is calculated using price movements of the stock we're analyzing. Those movements are then compared to the movements of an overall market indicator, such as a market index, over the same period of time.

Beta Rules of Thumb
Beta values are fairly easy to interpret too. If the stock's price experiences movements that are greater - more volatile - than the stock market, then the beta value will be greater than 1. If a stock's price movements, or swings, are less than those of the market, then the beta value will be less than 1.

Since increased volatility of stock price means more risk to the investor, we'd also expect greater returns from stocks with betas over 1. The reverse is true if a stock's beta is less than 1. We'd expect less volatility, lower risk, and therefore lower overall returns.

CAPM Theory and Beta
During our discussions of calculating stock prices, and our follow up discussion of the capital asset pricing model, or CAPM, we explained how we could calculate the expected return on an investment by examining risk-free investments, expectations of the stock market, and stock betas.

For example, by using the following CAPM formula we can calculate the expected rate of return on an investment as:

Expected Rate of Return = r = rf + B (rm - rf)

Where:
• rf = The risk-free interest rate is the interest rate the investor would expect to receive from a risk-free investment. Typically, U.S. Treasury Bills are used for U.S. dollars and German Government bills are used for the Euro.

• B = A stock beta is used to mathematically describe the relationship between the movements of an individual stock versus the market itself. Investors can use a stock's beta to measure the risk of a security versus the market.

• rm = The expected market return is the return the investor would expect to receive from a broad stock market indicator such as the S&P 500. For example, over the last 17 years or so, the S&P 500 has yielded investors an average annual return of around 8.10%.

If we were to translate this CAPM formula into words, we'd say the following:
"The expected return on an investment is equal to the return on a risk-free investment plus the risk premium that's associated with the stock market itself, adjusted for the relative risk of the common stock we've chosen."

Stock beta values are a key element when using the CAPM.

Advantages and Disadvantages of Beta

In the next two sections, we're going to discuss the advantages and disadvantages of betavalues. The outcome of this discussion should be an overall understanding of how to use this measure in practice. For example, you may want to look at a stock's beta before making a purchase decision. That's a good step to take as part of your stock research, as long as you understand what the value is telling you.

Advantages of Beta
The calculation of beta is based on extremely sound finance theory. The CAPM pricing theory is about as good as it gets when it comes to pricing stocks, and is far easier to put into practice when compared to the Arbitrage Pricing Theory, or APT. If you're thinking about investing in a company's stock, then the beta allows you to understand if the price of that security has been more or less volatile than the market itself. That's certainly a good factor to understand about a stock you're planning to add to your portfolio.

If we understand the theory behind beta, then it's easy to understand how emerging technology stocks typically have beta values greater than 1, while 100 year-old utility stocks typically havebeta values less than 1. In fact, in March 2007 Priceline.com had a beta of 3.4 while Public Service Enterprise Group had a beta of 0.57. It's nice when theory seems to work in the real world.

Disadvantages of Beta
We're an advocate of value investing, which includes conducting stock research that focuses on a company's fundamentals and an understanding of financial ratios before investing in a stock. Unfortunately, if you're calculating stock beta values using price movements over the past three years, then you need to bear in mind that the "past performance is no guarantee of future returns" rule applies to beta values.

Beta is calculated based on historical price movements, which may have little to do with how a company's stock is poised to move in the future. Because the measure relies on historical prices, it's not even possible to accurately calculate the beta of newly issued stocks.

Beta also doesn't tell us if the stock's movements were more volatile during bear markets or bull markets. It doesn't distinguish between large upswing or downswing movements. So while betacan tell us something about the past risk of a security, it tells us very little about the attractiveness or the value of the investment today or in the future.

Beta Calculations
You'll find calculated values of beta on all of the major stock reporting websites: Yahoo Finance, MSN Money, and Google Finance all report stock beta values. You can also calculate beta yourself using a fairly straightforward linear regression technique that's available in a spreadsheet application such as Microsoft's Excel or OpenOffice Calc.

In fact, to calculate a stock's beta you only need two sets of data:
• Closing stock prices for the stock you're examining.
• Closing prices for the index you're choosing as a proxy for the stock market.

Most of the time, beta values are calculated using the month-end stock price for the security you're examining, and the month end closing price of the stock exchange.

The formula for the beta can be written as:
Beta = Covariance (stock versus market returns) / Variance of the Stock Market


Alpha Values
Finally, in our spreadsheet we also included a calculation of alpha values. Alpha is a measure of excess returns on an investment, which has been adjusted for risk. It's commonly used to assess the performance of a portfolio manager (such as the case with a mutual fund) as it's an indicator of their ability to provide returns in excess of a benchmark such as the S&P 500.
For example:
• If alpha < risk-free investment return, then the fund manager has destroyed value;
• If alpha = risk-free investment return, then the fund manager has neither created nor destroyed value; and
• If alpha > risk-free investment return, then the fund manager has created value.
Edited Article from moneyzine

 

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What Is The Intrinsic Value Of A Stock?

Intrinsic value is a topic discussed in philosophy wherein the worth of an object or endeavor is derived in-and-of-itself - or in layman's terms, independent of other extraneous factors. A stock also is capable of holding intrinsic value, outside of what its perceived market price is, and is often touted as an important aspect to consider by value investors when picking a company to invest in.
Outside of this area of analysis, some buyers may simply have a "gut feeling" about the price of a good without taking into deep consideration the cost of production, and roughly estimate its value on the expected utility he or she will derive from it. Others may base their purchase on the much publicized hype behind an asset ("everyone is talking positively about it; it must be good!") However, in this article, we will look at another way of figuring out the intrinsic value of a stock, which reduces the subjective perception of a stock's value by analyzing its fundamentals and determining the worth of a stock in-and-of-itself (in other words, how it generates cash).
For the sake of brevity, we will exclude intrinsic value as it applies to call and put options.
Dividend Discount ModelWhen figuring out a stock's intrinsic value, cash is king. Many models that calculate the fundamental value of a security factor in variables largely pertaining to cash: dividends and future cash flows, as well as utilize the time value of money. One model popularly used for finding a company's intrinsic value is the dividend discount model. The basic DDM is:
Where:
Div = Dividends expected in one period
r = Required rate of return
One variety of this model is the Gordon Growth Model, which assumes the company in consideration is within a steady state - that is, with growing dividends in perpetuity. It is expressed as the following:
Where:
DPS₁= Expected dividends one year from the present
R = Required rate of return for equity investors
G = Annual growth rate in dividends in perpetuity
As the name implies, it accounts for the dividends that a company pays out to shareholders which reflect on the company's ability to generate cash flows. There are multiple variations of this model, each of which factor in different variables depending on what assumptions you wish to include. Despite its very basic and optimistic in its assumptions, the Gordon Growth model has its merits when applied to the analysis of blue-chip companies and broad indices.
Residual Income ModelAnother such method of calculating this value is the residual income model, which expressed in its simplest form is:
Where:
B₀= Current Per-Share Book value
B_n= Expected per-share book value of equity at n
ROE_n= Expected EPS
r = Required rate of return on investment
If you find your eyes glazing over when looking at that formula - don't worry, we are not going to go into further details. What is important to consider though, is how this valuation method derives the value of the stock based on the difference in earnings per share and per-share book value (in this case, the security's residual income), to come to an intrinsic value for the stock. Essentially, the model seeks to find the intrinsic value of the stock by adding its current per-share book value with its discounted residual income (which can either lessen the book value, or increase it.)

Discounted Cash Flow
Finally, the most common valuation method used in finding a stock's fundamental value is discounted cash flow (DCF) analysis. In its simplest form, it resembles the DDM:
Where:
CF_n = Cash flows in period n.
d = Discount rate, Weighted Average Cost of Capital (WACC)
In Ben McClure tutorial DCF Analysis, he goes about using the model to determine a fair value for a stock based on projected future cash flows. Unlike the previous two models, DCF analysis looks for free cash flows - that is, cash flow where net income is added with amortization/depreciation, and subtracts changes in working capital and capital expenditures. It also utilizes WACC as a discount variable to account for the time value of money. McClure's explanation provides an in-depth example demonstrating the complexity of this analysis, which ultimately determines the stock's intrinsic value.

Why Intrinsic Value MattersWhy does intrinsic value matter to an investor? In the listed models above, analysts employ these methods to see if whether or not the intrinsic value of a security is higher or lower than its current market price - allowing them to categorize it as "overvalued" or "undervalued." Typically, when calculating a stock's intrinsic value, investors can determine an appropriate margin of safety, where the market price is below the estimated intrinsic value. By leaving a 'cushion' between the lower market price and the price you believe it's worth, you limit the amount of downside that you would incur if the stock ends up being worth less than your estimate.
For instance, suppose in one year you find a company that you believe has strong fundamentals coupled with excellent cash flow opportunities. That year it trades at $10 per share, and after figuring out its DCF, you realize that its intrinsic value is closer to $15 per share - a bargain of $5. Assuming you have a margin of safety of about 35%, you would purchase this stock at the $10 value. If its intrinsic value drops by $3 a year later, you are still saving at least $2 from your initial DCF value and have ample room to sell if the share price drops with it.
For a beginner getting to know the markets, intrinsic value is a vital concept to remember when researching firms and finding bargains that fit within his or her investment objectives. Though not a perfect indicator of the success of a company, applying models that focus on fundamentals provide a sobering perspective on the price of its shares.

The Bottom LineEvery valuation model ever developed by an economist or financial academic is subject to the risk and volatility that exists in the market as well as the sheer irrationality of investors. While calculating intrinsic value may not be a guaranteed way of mitigating all losses to your portfolio, it does provide a clearer indication of a company's financial health, which is vital when picking stocks you intend on holding for the long-term. Moreover, picking stocks with market prices below their intrinsic value can also help in saving money when building a portfolio.
Although a stock may be climbing in price in one period, if it appears overvalued, it may be best to wait until the market brings it down to below its intrinsic value to realize a bargain. This not only saves you from deeper losses, but allows for wiggle room to allocate cash into other, more secure investment vehicles like bonds and T-bills.

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