Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Two – WACC – Forty years on
Exhibit 2.8: Beta as measure of covariance
Beta as covariance
High Beta
Market
Low Beta
Examples of high Beta stocks are those where the company supplies one of the
more volatile components of the overall economy, such as housebuilding, or
those that are very sensitive to asset prices, such as life insurance companies.
Examples of low Beta stocks are utilities, or food retailers. A point to which we
shall return is the fact that the Beta of a share can be increased or decreased by
the company financing itself with more or less debt.
Measuring Betas is normally done by a partial regression of the returns on the
asset over a run of periods against returns on the overall equity market over the
same periods. Exhibit 2.9 shows a plot of returns on a stock versus returns on a
market over a series of periods, often, in practice, monthly returns over three or
five years. The historical Beta of the stock is then estimated using the slope of the
resulting line. There are clearly statistical problems with this. The correlation
coefficients for individual companies are often very poor. And, in any case, the
theory applies to expected Betas, not historical ones. In practice, Betas are
generally calculated in this way, using databases such as those marketed by
Bloomberg or DataStream.
There are two problems with standard calculations for Beta. The first is that they
are backward looking, whereas it is prospective Betas that should drive discount
rates. The second is that the statistical significance of many of the calculations is
very poor. Finally, there is the usual problem with time-periods. Over what period
should we be measuring Betas?
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