Friday, March 01, 2013

Parameters that explain the value of beta

(a) Sensitivity of stock to the economy

The greater the effect of the state of the economy on a business sector, the higher is its β – temporary work is one such highly exposed sector. Another example is auto-makers, which tend to have a β close to 1. There is an old saying in North America, “As General Motors goes, so goes the economy”. This serves to highlight how GM’s financial health is to some extent a reflection of the health of the entire economy. Thus, beta analysis can show how GM will be directly affected by macroeconomic shifts in the economy.

(b) Cost structure

The greater the proportion of fixed costs to total costs, the higher the breakeven point, and the more volatile the cash flows. Companies that have high ratio of fixed costs (such as cement makers) have a high β, while those with a low ratio of fixed costs (like mass- market service retailers) have a low β.

(c) Financial structure

The greater a company’s debt, the greater its financing costs. Financing costs are fixed costs which increase a company’s breakeven point and, hence, its earnings volatility. The heavier a company’s debt or the more heavily leveraged the company is, the higher is the β of its shares. 

(d) Company performance 

The quality of management and the clarity and quantity of information the market has about a company will all have a direct influence on its beta. All other factors being equal, if a company gives out little or low quality information, the β of its stock will be higher as the market will factor the lack of visibility into the share price.

(e) Earnings growth

The higher the forecasted rate of earnings growth, the higher the ß. Most of a company’s value in cash flows are far down the road and thus highly sensitive to any change in assumptions. 
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