What are the Uses of Beta?

What are the properties of high and low beta stocks?

Cyclical stocks are those with high betas, in other words greater than plus one. They’re expected to outperform when markets rise and underperform when they fall. Low beta stocks, those with a positive beta of less than plus one, are considered to be defensive stocks, which are expected to hold up relatively well when the markets are falling and underperform in rising markets. Counter cyclicals are those with negative betas and move against the market.

What are the uses of beta?

Hedging strategies:

Say for example an investor owns a stock that has risen strongly and now thinks the market will fall. Selling the stock might crystallise an unwanted tax liability. Fund managers might be prevented from selling because of internal constraints on the fund or by regulatory rules. So, rather than selling,  an alternative would be to protect the value of the portfolio, in other words to hedge it. This could be done by buying negative beta stocks or, if allowed to, shorting other positive beta stocks, or possibly by selling index futures. The aim is to neutralise the exposure by achieving a net zero beta. This should protect against adverse movements and maintain the value of the portfolio. Losses to the portfolio should be offset by gains from the hedge, and vice versa.

Equity Valuation:

In the world of equity valuation, discounted cash flow or DCF, is a fundamental technique used in the valuation of companies and therefore their shares. It usually involves discounting free cash flows generated by the company over time by the company’s weighted average cost of capital, WACC for short. The weighted average cost of capital has two components. The cost of debt and the cost of equity. The cost of equity is very often obtained through the capital asset pricing model, or CAPM for short, which in turn uses beta to establish the return investors would expect to receive in order to hold the stock.