What is Beta?

Of all the concepts in finance, Beta may cause the most confusion.

In its simplest form beta is just raw math. It’s the slope of the line in a regression and in substance it captures the relationship between the independent and dependent variables.

In the finance world, we typically look at Beta based on a regression analysis of the movements of a stock (the dependent variable) and the movements of the overall market (the independent variable).

This relationship helps us to understand how volatile a stock is relative to the overall market.

When we value a business, we incorporate this measure of volatility to dial the targeted rate of return of an investor (i.e. the cost of equity) up or down based on the level of risk that is taken.

It’s important to understand, though, as I often tell my students, “the beta doesn’t know that you’re calculating it.”

So, you could say that in a vacuum, beta means nothing. But there’s more to this story.

You have to think through whether the context around the beta makes sense in terms of the time period over which it’s being measured.

If the stock that’s being measured looked very different in the past than it will look in the future, the current beta that’s calculated isn’t very useful.

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