1.. BETA:: KNOW THE RIISK 1 BETA KNOW THE R SK 2.

How should investors assess risk in the stocks they buy or sell? As you can imagine, the concept of risk is hard to pin down and factor into stock analysis and valuation. Is there a rating--some sort of number, letter, or phrase--that will do the trick? One of the most popular indicators of risk is a statistical measure called beta. Stock analysts use this measure all the time to get a sense of stocks' risk profiles. To learn about the basics of beta, take a look at Beta: Gauging Price Fluctuations. Here we shed some light on what the measure means for investors. While beta does say something about price risk, it does have its limits for investors looking for fundamental risk factors.

3. Beta Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. 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. Beta is a key component for the capital asset pricing model (CAPM), which is used to calculate cost of equity. 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. Advantages of Beta To followers of CAPM, beta is a useful measure. A stock's price variability is important to consider when assessing risk. Indeed, 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. Besides, beta offers a clear, quantifiable measure, which makes it easy to work with. 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 to understand. It's a convenient measure that can be used to calculate the costs of equity used in a valuation method that discounts cash flows. Disadvantages of Beta However, if you are investing in a stock's fundamentals, beta has plenty of

shortcomings. For starters, beta doesn't incorporate new information. Consider the electrical utility company American Electric Power (AEP). Historically, AEP has been considered a defensive stock with a low beta. But when it entered the merchant energy business and assumed high debt levels, AEP's historic beta no longer captured the substantial risks the company took on. At the same time, many technology stocks, such as Google, are so new to the market they 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. But 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. The trouble is that beta, as a proxy for risk, doesn't distinguish between upside and downside price movements. For most investors, downside movements are risk while upside ones mean opportunity. Beta doesn't help investors tell the difference. For most investors, that doesn't make much sense. There is an interesting quote from Warren Buffett in regards to the academic community and its attitude towards value investing: "Well, it may be all right in practice, but it will never work in theory." Value investors scorn the idea of beta because it implies that a stock that has fallen sharply in value is more risky than it was before it fell. A value investor would argue that a company represents a lower-risk investment after it falls in value--investors can get the same stock at a lower price despite the rise in the stock's beta following its decline. Beta says nothing about the price paid for the stock in relation to its future cash flows. If you are a fundamental investor, consider some practical recommendations offered by Benjamin Graham and his modern adherents. Try to spot well-run companies with a "margin of safety"--that is, an ability to withstand unpleasant surprises. Some elements of safety come from the balance sheet, like having a low ratio of debt to total capital. Some come from consistency of growth, in earnings or dividends. An important one comes from not overpaying. Stocks trading at low multiples of their earnings are safer than stocks at high multiples. Conclusion It's important for investors to make the distinction between short-term risk-where beta and price volatility are useful--and longer-term, fundamental risk,

where big-picture risk factors are more telling. High betas may mean price volatility over the near term, but they don't always rule out long-term opportunities. 4. Volatility In other words, volatility refers to the amount of uncertainty or risk about the size of changes in a security's value. A higher volatility means that a security's value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security's value does not fluctuate dramatically, but changes in value at a steady pace over a period of time. One measure of the relative volatility of a particular stock to the market is its beta. A beta approximates the overall volatility of a security's returns against the returns of a relevant benchmark (usually the S&P 500 is used). For example, a stock with a beta value of 1.1 has historically moved 110% for every 100% move in the benchmark, based on price level. Conversely, a stock with a beta of .9 has historically moved 90% for every 100% move in the underlying index. COST OF EQUITY COST OF EQUITY In finance, the cost of equity is the minimum rate of return a firm must offer shareholders to compensate for waiting for their returns, and for bearing some risk The cost of equity is calculated by the following formula:

The formula above calculates the cost of equity based on a firm's current rate of return. If one assumes a perfect market, industry-specific costs of equity reflect the riskiness of particular industries. A high cost of equity would then indicate a higherrisk industry that should command a higher return to compensate for the higher risk. However, there are also a variety of other ways to estimate the cost of equity. For example, using the CAPM model, the cost of equity is the product of the Market Risk Premium and the equity's beta plus the risk-free interest rate.

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