How it works
Beta is usually calculated as the slope of a line fitted through the share's returns plotted against the market's returns, over a period such as five years of monthly data. The result depends on the market index and the time window you choose, so betas from different sources can differ.
Analysts also talk about levered and unlevered beta. Levered beta includes the effect of the company's debt. Unlevered beta removes it, so businesses with different amounts of debt can be compared. Debt makes shares riskier, so levered beta is higher than unlevered beta.
Unlevered beta = Levered beta ÷ [1 + (1 − tax rate) × Debt ÷ Equity]
Cost of equity = Risk-free rate + Beta × Equity risk premium
A simple example
How it is used
- Estimating the cost of equity with CAPM.
- Valuing private companies, using the average beta of similar listed companies.
- Judging how risky a share is within a portfolio.
Common mistakes
- Using one company's beta when the average of several similar companies would be more reliable.
- Mixing levered and unlevered betas.
- Using a beta measured against an unsuitable market index.
- Treating beta as the only measure of risk. It captures market risk, not every risk.
Questions
What is a good beta?
There is no good or bad beta. A low beta means smaller swings with the market, which some investors prefer. A high beta can bring a higher expected return, and more risk.
Can beta be negative?
Yes, though it is rare. A negative beta means the asset tends to move in the opposite direction to the market.
Keep learning
- What is CAPM and the cost of equity?
- What is alpha in finance?
- What is WACC (weighted average cost of capital)?
- Guide: Business valuation
- Cost of equity and WACC calculator
- Damodaran: betas by sector (global)
- Damodaran: betas by sector (US)
- Glossary: Beta
- Glossary: Levered and unlevered beta
- Glossary: Capital asset pricing model (CAPM)
- Glossary: Volatility (standard deviation)