November 27, 2006
Red-Hot Smoking Beta
Analysis of:
Lowering the Bar (on cost of capital) | www.cfo.com
This analysis is solely the work of the author. It has not been edited or endorsed by GLG.
Implications:
Analysis:
- The author writes on declining Betas and the impact on share pricing and hurdle-rate selection. The author properly points out that falling Betas can be used to create hurdle-rates were just too low. The author further notes that Beta came back to historical levels for non-tech stocks.
- The author claims that these changes could be the result of either greater fluctuation in stock price or in broader market. The author further calls for caution in situations where the Beta declines to extremely low levels.
The following analysis will discuss what Beta actually represents, and how to use them more effectively.
Analysis:
- The conclusion drawn is that a company or investors should not be taken in by falling Betas and that recent decline was only temporary and that for non-tech stocks returned to previous levels. The analysis omits some issues that are and were much apart of the issue.
- First, Betas can drop precipitously when a company is in financial trouble. The old Public Service of New Hampshire’s Beta got very small indeed before NU bought it. Was that a sign of lowered risk? Hardly, the company was almost dead. All Beta tells us is how much the share price moves with the broader market. In this case and others, the stock became disconnected from the market but not from lower risk. Using Beta for share valuation would be counterintuitive in such instances.
- Another reason for declining Beta is company-generated news. The article contains a graph of Electric Utility Betas. The fundamental range of .60 has not changed significantly in over two decades, with the gross amount split evenly between asset and leverage Beta. In this industry, many of the companies had declining Beta and R-Squared, while others didn’t, during the time in question. The difference was the news relating to deregulation and diversification, and the company’s plans: the more news, the more the decline in Beta. The reason, of course, was simply that the stock moved on expectations, good or bad, without any fundamental change in operations.
- If changes from diversification had actually been producing results, Beta might have risen both from asset and leverage Beta components in the new ventures and the method used to finance them. In point of fact Duke Energy’s Beta fell based on their story, then really took a hit when investors discovered real flaws in the company’s energy contract valuations. A priori, it could be reasoned that energy trading is far more risky than energy generation, but that would not have been evidence solely from evaluation of the Beta performance.
- Lastly, falling Betas might be indicative of the strengthening of one leg of the fraud triangle, incentive. If a company’s share price increases based on the company announcements, this change can create real incentives to meet those expectations by fair means or foul. A good way to find these instances is to look for falling Betas and R-Squareds, then look to price performance relating to company news.
- Beta only shows how much the stock moves with the broader market and it should be obvious now that a declining Beta is not indicative of declining risk or a decline in capital cost.
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