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Calculating Beta Excel
Calculating Beta Excel
Calculating Beta Excel
Introduction:
In 1990, William Sharpe won a Nobel Prize in Economics for his work in
developing the Capital Asset Pricing Model (CAPM). Traditionally the CAPM
has been the basis for calculating the required return to the shareholder. This
figure in turn has been used to calculate the economic value of the stock and the
Weighted Average Cost of Capital (WACC) for capital budgeting. In recent
years, the CAPM has been attacked as an incomplete model for explaining
market pricing behavior, but academics and practitioners cannot agree on a good
replacement. And so the CAPM remains an important model in practical
investment and financial management decision making.
Calculating Beta:
The most important component in calculating the required return to
shareholder (from the CAPM) is the companys beta. The CAPM can be
succinctly stated as:
k s k RF k M k RF s k RF Market Risk Premium s
[1]
The original model was conceived of theoretically, and was expected to be
forward looking. Careful reading of Sharpes original work show that the
market assesses systematic risk looking at expected future covariance of the
companys returns with that of the overall market. It is assumed that these
covariances are unbiased and efficient estimates of the observed relationships ex
post facto.
Traditionally the CAPM relationship is estimated using simple regression
on historical outcomes, where ks is the y variable, and kM-kRF (or the market risk
premium) is the only x variable. Care must be taken that the returns plugged
into the regression are all for the same period. Calculated stock returns should
be annualized if the risk-free rate is an annual rate.
The market risk premium is merely the difference between the return to
the market portfolio and the risk-free rate. Academics typically use a value
weighted portfolio to proxy for the market portfolio, and a one-month Treasury
Bill rate to proxy for the risk-free rate. Practitioners can use equally weighted
portfolios (but not all do) and tend to use longer term Treasury bonds for the
risk-free rate. The biggest contention between the two is over the risk-free rate
proxy. Academics want a rate that is free from all risk, including interest rate
risk. Practitioners want a default-risk-free instrument with a more comparable
maturity to stock.
Bringing the Data into Excel:
For our purposes, we will use publicly available information to estimate
our companys beta. We do not have access to the market weighted or value
3. Next we need to get price (return) data for the stock over the most
recent few years. Traditionally either monthly or weekly data are
used for this purpose. We will use monthly data if enough years
are available, so click on Monthly. The maximum time series is the
default displayed in Yahoo, make sure you have about five years of
data if you are going to use monthly data. So that the data are for
the same period (are synchronous) as the Treasury bond data, we
must change the Date Range to be on the first of each month. Then
click on the Get Prices button.
will ask whether you want to save or open it. You can do either
one, but you will need it in Excel to run a regression. That means
that if you choose to open it, you will have to open Excel, then copy
and paste the information over to Excel.
5. Now we need to collect the Treasury Bond rate. For that
information, you will need to go to the Federal Reserve Bank of St.
Louis (http://research.stlouisfed.org/fred2/series/GS20/). Click on the
Download Data link, and follow the links at the bottom of the next
page, to download the monthly 20 year bond rate.
6. Next we need the market return data. This is gathered the same
way the stock price data was gathered.
First go to
http://finance.yahoo.com; then click on S&P 500. Then follow the
same directions listed for the stock prices (steps 2, 3 and 4 above) to
download the index levels for the S&P 500.
Adjusting the Data:
The data will have to be lined up so that they cover the same month, and
so that they are return data. We will also need to adjust the data so that they are
annual returns, since we want annual required return, and we will have to adjust
the Treasury yield data, since 3.80 means 3.80% (which should say 0.0380). For
the explanation below, it is assumed that each component downloaded (stock
price data, Treasury bond rates, and S&P levels), are each on a separate sheet in
Excel.
The first step is going to the sheet containing the Treasury yield data and
putting it in the same order as the Yahoo provided data. This is rather simple:
1. Move the cellpointer to the first date in the list.
Note, alternatively, you can just move your cellpointer as indicated in step
1 above, then click on the Sort Descending
button if it is displayed.
Now we need to calculate the return figures for both the stock price and
the S&P levels. These are done exactly the same way. Therefore, only the stock
price will be shown. You will, however, need to do both. The monthly return is
simply the percent change in Adj. Close from one month to the next. To get the
annualized return we will simply multiply by 12:
Normally, the Treasury data is not as up-to-date as the stock price data.
But one lost observation makes little difference.
Estimating Beta:
As mentioned above, estimating beta is simply a matter of running a
simple regression model. To do that in Excel, we will use the regression
capabilities described earlier when we projected our income statement:
1. Click on the Tools menu.
2. Choose Data Analysis (if it doesnt show up on the list, follow the
directions listed under the notes to income statement projections to
get it to show up).
3. Choose Regression from the dialog box.
4. If you are using monthly data, use about five years worth of data,
entering the stock return data as the Y variable, and Risk Premium
as the X variable. Fill in the new worksheet name, then click OK.
3. Click Next, then click on the Series tab at the top of the dialog box.
Click in the X variable range and enter the first sixty (60) risk
premium figures on the summary sheet. Be sure these are the same
rows as those entered for the stock returns.
4. After both series are entered, then click Next. I would enter the
labels into the X and Y axes labels, then click Next.
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Both of these methods will yield the same answer if you do them
correctly. The graphical method shows more of what it is doing.
Interpreting the Regression Output:
First, lets discuss how to estimate the firms required return. Equation [1]
suggests that we only need to multiply the beta by the risk premium, then add
the risk-free rate. As mentioned in the textbook, we might want to adjust our
beta before estimating our required return. The textbook adjusts the beta for
mean reversion as follows:
Adjusted 0.67 Estimated 0.33
[2]
In practice, the adjusted beta is used in equation [1]. In addition, the
expected return to the market is rarely used in practice. Instead, an estimate of
the risk premium is used. Some researchers have estimated that the risk
premium has been relatively stable at between 3.5% and 6.5%. Again our text
likes to use an average of 5%, so we can do the same. And since we used the 20
year bond rate thus far, we can continue.
For example, if our regression estimated a beta of 1.5548, and the current
20 year bond rate were 4.97%, then the required return to the shareholder would
be calculated as follows (note in the Excel sheet where the beta estimate is
found):
Adjusted 0.671.5548 0.33 1.3717
k s k RF Market Risk Premium s 4.97% 5% 1.3717 11.8286%
11
12
0
0
2
3
1 k
1 k
1 k
1 k n
2
P0
[3]
In this model, the only dividend in the model is the last observed
dividend (D0), which grows at a constant rate (g), and is discounted at the
required rate of return (k). To solve for P0, we will first multiply both sides of
equation 3 by (1+g)/(1+k):
D 1 g
D 1 g
D 1 g
1 g D0 1 g
0
0
P0
0
2
3
4
1 k
1 k
1 k
1 k n 1
1 k
2
n 1
[4]
Now if you subtract equation 4 from equation 3, you are left with the
following equality:
1 g D0 1 g D0 1 g
P0 1
1 k
1 k n 1
1 k
n 1
[5]
At this point we will make two observations. First, note that as long as
k>g, then as n gets large, the final term gets very small. In fact, the limited of the
last term as n approaches infinity, is zero. Therefore, we will ignore it from here
on out. The second observation concerns the left side of the equality:
13
1 g 1 k 1 g k g
1 1 k 1 k 1 k 1 k
[6]
[7]
Now if we solve for P0, we get the following equality, which is usually
called the Gordon Constant Growth Model:
P0
D0 1 g
D 1
kg
kg
[8]
In the final form, the numerator can either be the last dividend, allowed to
grow at the constant rate, or it could be restated as the expected dividend in the
next period, since the two are identical under Gordons simplifying assumptions.
For many applications, this form assumes too much. For many firms, the
implied growth is unlikely. Remember, that the growth rate is expected to
continue forever. Unless the growth rate is rather low, most firms could not
expect constant growth in dividends that is much higher than inflation1.
Smaller, younger companies may have a high growth period in the
corporate life cycle. That high growth period may be followed by a slower
growth period. To accommodate this growth model, Gordons original model
has been adjusted for two growth phases as follows (without derivation):
P0
D0 1 g 1 1 g 1
1
k g 1 1 k
1 g T D0 1 g 2
1
k
1
k g2
[9]
14
D Avg 3rdYr 1 g
4
k g
4
4
[10]
This price represents the value in time 12, of all future cash flows. Since
it is denominated in time 12 dollars, we will need to take its present value. The
easiest way of accomplishing that, is to add it to the periodic cash flow and take
them both together. Therefore, another line is added to sum all period cash
flows (even though the only period with a sum is the final one. The screen
capture below demonstrates the general spreadsheet layout.
Note that the example company, Rocky Shoe and Boot, does not list depreciation on its income
statement. We used the change in accumulated depreciation from the balance sheet to estimate
the period by period depreciation expense.
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