Estimating Beta - New York University
Estimating Beta
The standard procedure for estimating betas is to regress stock returns (Rj) against market returns (Rm) -
Rj = a + b Rm
? where a is the intercept and b is the slope of the regression.
The slope of the regression corresponds to the beta of the stock, and measures the riskiness of the stock.
This beta has three problems:
? It has high standard error
? It reflects the firm's business mix over the period of the regression, not the current
mix
? It reflects the firm's average financial leverage over the period rather than the
current leverage.
Aswath Damodaran
63
Beta Estimation: The Noise Problem
Aswath Damodaran
64
Beta Estimation: The Index Effect
Aswath Damodaran
65
Solutions to the Regression Beta Problem
Modify the regression beta by
? changing the index used to estimate the beta
? adjusting the regression beta estimate, by bringing in information about the
fundamentals of the company
Estimate the beta for the firm using
? the standard deviation in stock prices instead of a regression against an index
? accounting earnings or revenues, which are less noisy than market prices.
Estimate the beta for the firm from the bottom up without employing the regression technique. This will require
? understanding the business mix of the firm
? estimating the financial leverage of the firm
Use an alternative measure of market risk not based upon a regression.
Aswath Damodaran
66
The Index Game...
Aracruz ADR Aracruz
Aracruz ADR vs S&P 500
80
60
40 20
0
- 20
- 40
-20
- 10
0
10
S&P
A r a c r u z ADR = 2.80% + 1.00 S&P
Aracruz vs Bovespa
1 40
1 20
1 00
80
60
40
20
0
- 20
- 40
20
-50
-40
- 30
-20 -10
0
10
20
30
BOVESPA
A r a c r u z = 2.62% + 0.22 Bovespa
Aswath Damodaran
67
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