How to calculate company beta: with definition and formula

By Indeed Editorial Team

Published 24 May 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

In the world of business, stability is key, and beta testing helps stability. Understanding the situation of your finances is at the heart of creating budgets and revenue plans for the long term, which is only possible when you fully understand how stable or how volatile a company's prospects are. Determining company beta is the process that assists you in doing this. In this article, we discuss what company beta is, why it's so fundamental in the execution of business plans and how you calculate it to get a better idea of an organisation's current status.

Why calculate company beta?

To understand why you calculate company beta, it's important to understand exactly what company beta is and what it means for the company in question. Beta is a measure of the volatility and risk of a stock when compared to the rest of the market. A company's beta is a good metric when investing, as it offers an idea of the return of an asset and whether it's excessively volatile compared to the rest of the market.

Primarily used in the capital asset pricing model, investment funds and financial advisers use company beta to establish whether an investment is advisable, the risks of investing and the potential benefits of the investment. For example, low-risk investors tend to work with companies with low beta, as they show lower risk, with the downside of prospective reward being less. The opposite applies to high-risk investors, those investing in high-risk spaces and finding marginal gains over competitors that baulk at the sight of higher risks.

Formula to calculate company beta

The equation to calculate company beta is:

ΔSi = α + βi × ΔM + e
where:
ΔSi = change in price of stock i
α = intercept value of the regression
βi = beta of the i stock return
ΔM = change in the market price
e = residual error term

By rebalancing this equation to provide the beta alone, the equation becomes:

βi = (ΔSi / ΔM + e) - α

Although this is the more complex and formulaic method of calculating company beta, a simpler way of doing so is taking covariance within a market and dividing it by the variance of an individual stock. Depending on the stock or business itself, accessing information from private companies is difficult unless you have access to the internal information of the company. In these cases, other, potentially less accurate, methods are necessary when estimating the beta of a company.

Related: What is quantitative analysis? (With definitions and examples)

Calculating company beta from example businesses

Below are example calculations from a range of different companies. These companies are fictional and provide examples of variation in what company beta means in a more practical sense. Read on for examples of calculating company beta and the lessons that company beta teaches about a company's income and share prices:

Hornby Industries - low company beta

Hornby Industries is in the renewable energy sector and has a reliable rate of growth, as stock price variance is 2% each year. The covariance of the wider industry, by comparison, is 5%, as the industry is in a state of flux. Dividing the variance of Hornby Industries by the covariance of the wider industry means that the calculation of company beta is:

V = Variance of Hornby Industries = 2%
CV = Covariance of renewable energy sector = 5%
βi = Company beta of Hornby Industries
βi = V/CV = 2/5 = 0.4
∴ βi = 0.4

As the company beta of Hornby Industries is lower than one, the company's share price is less volatile than the average within the market.

Brennan Incorporated - high company beta

Brennan Incorporated is a leader in the fossil fuel industry. Because of varying supply, they're struggling to produce consistent amounts of materials, leading to a stock price variance of 3.6%. By comparison, the rest of the market makes use of independent extraction methods and remains stable, with a stock price covariance of only 0.9%. By dividing the variance of Brennan Incorporated by the industry's covariance, you reach the company beta of Brennan Incorporated:

V = Variance of Brennan Incorporated = 3.6%
CV = Covariance of renewable energy sector = 0.9%
βi = Company beta of Brennan Incorporated
βi = V/CV = 3.6/0.9 = 4
∴ βi = 4

Here, volatility in stock price leads to Brennan Industries having a company beta of 4. This means that the stock price of Brennan Industries is four times that of the average company in the field. Investors act on this information to form investment conclusions in the long run.

Horrobin's - monopolistic company beta

Horrobin's is a monopolistic company in the medical supplies industry. Where the aforementioned businesses are amongst competitors, Horrobin's is a monopoly. This means that they're the only company in the industry, with barriers to entry being excessively high. Allen Pharmaceuticals and Grimescorp, for example, can't enter the market because of regulatory blockages. Horrobins' stock variance of 2% is identical to that of the market. The company beta calculation is:

V = Variance of Horrobin's = 2%
CV = Covariance of renewable energy sector = 2%
βi = Company beta of Horrobin's v βi = V/CV = 2/2 = 1
∴ βi = 1

Having a company beta of one means performing at precisely the market average. Monopolies inevitably have a company beta of one. This is because they're the only company in their industry, thus their variance and covariance figures are identical.

How is company beta useful?

Company beta is useful, although limiting its use to particular circumstances is an advisable route forward. For example, Horrobin's, as mentioned earlier, has a company beta of one, implying it has a high level of consistency. As a monopoly, this isn't representative of a wide dataset. Being aware of the size of datasets gives you a better understanding of the true nature of the industry and whether the information is as reliable as possible.

Approaching company beta with apprehension and using it as a guide is key, as company beta is an excellent tool when guiding investors towards individual stocks and shares to research in greater depth. As with any metric taken in isolation, company beta is incomplete and has the potential to mislead. Company beta is best implemented in investment strategies alongside thorough research and market analysis.

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When to use company beta

There are several situations in which company beta is beneficial. This is both to develop investment strategies and internal policy, as significant insight is present in company beta information. Read on for some situations in which company beta is a helpful metric, and why this metric is key for the situation in question:

Investing in new markets

Even the most experienced investors lack full market knowledge, and transitioning to investments in a different industry to normal is difficult without possession of full market data. Company beta in these cases provides face value information surrounding the volatility of individual businesses in the market, thus those that are reliable and stable investments.

Similarly, impact investment firms looking at new markets search for those with high beta on a downswing. This implies a stock with the potential to grow, thus short-term investments in these specific stocks have high short-term profit potential. Please note that high beta is no guarantee of rising prices, and potentially indicates ongoing price falls or rises.

Related: How to become a stock trader (with job and salary info)

Internal reviews

Publicly traded company reputations rely on effective management, and volatile prices indicate management that is falling below expectations. By examining company beta, management staff establish the broad public perception of their company as either a volatile one or a more stable business. Small retail investors are a large proportion of modern investing, thus stock prices present a summary of the company's perception amongst investing members of the public.

This information provides opportunities for business management. New staffing strategies oriented towards stability, implementation of greater financial reporting and a range of other strategies are useful. Although not considered a traditional KPI, company beta reveals business performance and perception in a more understated manner.

Comparison

Comparing a company to its opposition is inevitable, especially when you hold a personal interest in a company. Taking the beta from a key rival and comparing it to an organisation's own shows greater examination of their public perception and financial performances. Volatile opposition is positive for a company, demonstrating inconsistency in financial reporting and public perception. It's important to examine more details than company beta alone.

Company beta isn't a highly detailed metric and offers a simple overview of the stability of a share price. When searching for advantages over market opponents, delving into greater detail yields more results than surface-level analysis.

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