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Share Loading the player How should investors assess risk in the stocks they buy or sell? One of the most popular indicators of risk is a statistical measure called beta.
Analysts use this measure all the time to get a sense of stocks' risk profiles. While beta does say something about price risk, it has its limits for investors looking for fundamental risk factors.
Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a beta of 1. A stock that swings more than the market over time has a beta above 1. If a stock moves less than the market, the stock's beta is less than 1. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.
Recall that the cost of capital represents the discount rate used to arrive at the present value of a company's future cash flows. All things being equal, the higher a company's beta is, the higher its cost of capital discount rate.
The higher the discount rate, the lower the present value placed on the company's future cash flows. In short, beta can impact a company's share valuation. A stock's price variability is important to consider when assessing risk. If you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk.
Intuitively, it makes plenty of sense.
Think of an early-stage technology stock with a price that bounces up and down more than the market. It's hard not to think that stock will be riskier than, say, a safe-haven utility industry stock with a low beta.
Sure, there are variations on beta depending on things such as the market index used and the time period measured — but broadly speaking, the notion of beta is fairly straightforward. It's a convenient measure that can be used to calculate the costs of equity used in a valuation method that discounts cash flows.
The Disadvantages of Beta If you are investing in a stock's fundamentals, beta has plenty of shortcomings. For starters, beta doesn't incorporate new information. Consider a utility company: Company X has been considered a defensive stock with a low beta. When it entered the merchant energy business and assumed high debt levels, X's historic beta no longer captured the substantial risks the company took on.
At the same time, many technology stocks are relatively new to the market and thus have insufficient price history to establish a reliable beta. Another troubling factor is that past price movements are very poor predictors of the future.
Betas are merely rear-view mirrors, reflecting very little of what lies ahead. Furthermore, the beta measure on a single stock tends to flip around over time, which makes it unreliable. Granted, for traders looking to buy and sell stocks within short time periods, beta is a fairly good risk metric.
However, for investors with long-term horizons, it's less useful. Re-assessing Risk The well-worn definition of risk is the possibility of suffering a loss. Of course, when investors consider risk, they are thinking about the chance that the stock they buy will decrease in value.Guide to Dubai Duty Free, the tax free shopping mall at Dubai International Airport.
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