Beta (β): Definition and Use in CAPM
Beta measures a stock's sensitivity to market movements. It is a key input to Capital Asset Pricing Model (CAPM) when estimating the cost of equity.
CAPM Formula:
Use a long-term market return premium and an appropriate risk-free rate for your jurisdiction. Beta can be estimated from regression or using provider-supplied levered/unlevered betas.
Notes
- Beta > 1.0 indicates higher volatility than the market
- Beta < 1.0 indicates lower volatility than the market
- Unlevered beta removes the effect of financial leverage
- Historical beta may not predict future sensitivity
Why This Matters:
Beta is crucial for determining the required return on equity investments. It helps investors understand the risk-return tradeoff and is essential for calculating WACC in valuation models.