Market Multiples: Looking At Beta

October 9, 2007 by Joe Ponzio

If you aren’t familiar with beta, it is the measure of a stock’s volatility in relation to the rest of the market. If a stock has a beta of 1, it tends to move up and down at the same pace as the markets. Stocks with a beta greater than 1 move more quickly (up and down) than the markets as a whole.

Though conventional wisdom and Wall Street say high beta means high risk, well, “F” that. High beta is your friend. Let me explain.

The Setup

Let’s assume that the stock market is going to grow at 10% for the next year. Since the stock market has a beta of 1, let’s further assume that a stock with a beta of 1.5 should grow 15% over the next year. Today that stock is trading at $20 a share; next year, it should be trading at $23.00 (up 15%).

Not a bad return at all. Assuming this was a stellar business with an intrinsic value of $20 today and growing at 15%, there wouldn’t be a whole lot of risk involved in owning the company.

Calculating Beta

What if the company missed analysts expectations by a wide margin and the stock price plummeted to $10 (before you bought)? Assuming the markets did not move much, the beta for your company would shoot through the roof. Remember: Beta is a relative measure. If your stock price goes wildly up and down while the market stays flat, beta will be larger (perhaps much larger) than 1.

Now I ask you: Is a low-risk, $20 company any riskier because it is selling for $10?

Beta In Business

Remember: You are investing as if you owned the entire company. As such, you must realize that beta means nothing. In reality, no small business owner knows the beta of his or her company. It simply doesn’t exist.

Back To The Question

Is a low-risk, $20 company any riskier because it is selling for $10? It is not a question or price volatility, but of the risk of your valuation being off. If your valuation is rational, then the $10 price tag (and higher beta) would actually pose less risk.

If your $20 company had a net tangible book value (i.e., break up value) of $10 per share, and the stock price plummeted to $5, beta would be through the roof. Would your investment be at greater risk because you are buying $10 worth of assets for $5?

You Need High Beta

You can not beat the markets owning stocks that have a beta lower than 1. Why? Well, the markets have a beta of 1. If the markets return 10% and your goal is to earn 20%, you need a high beta. You need your stocks to move faster (or more) than the markets.

Keep in mind that beta says nothing about the price paid for the stock in relation to its future cash flows or its break-up value. It simply measures the past movement of the stock price in relation to other stock prices.

Put The Past Behind You

Finally, keep in mind that beta is a measure of past price movements. A stock’s beta can change in an instant, from well below 1 to well above 1, if the price begins to rapidly move up or down.

Should you screen for high beta stocks? Maybe. If you want to invest like Pabrai-looking for low-risk, high-uncertainty companies-you can see which stocks have plummeted and begin bottom feeding. If you want to invest in low-risk, high-certainty businesses, you want to look for low-beta stocks-companies that have grown considerably but have not seen stock price appreciation.

Both present great opportunities. So, look for stocks with a beta greater than, less than, or equal to one.

A Note From Joe Ponzio

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