Chapter Seven

BETA ANALYSIS OF EQUITY RETURNS

ANALYSIS III
 Chapter Seven

BETA ANALYSIS OF EQUITY RETURNS

ANALYSIS III

In this chapter devotion was paid to see the impact of beta on the
returns of stocks under study. A comparison of the return was done after
considering the beta effect and the expected yield on the stocks to know
whether the stocks under study were mispriced. The analysis of beta effect
was made in the light of Capital Asset Pricing Model (CAPM).

When a stock belonging to a particular risk class is purchased the

investor expects return on it commensurate with its risk. The greater the risk
of the stock the greater will be the expected rate of return. The rate expected
by the investor on his investment in a stock in relation to market risk is the
required rate of return. Individual Stock’s return and risk move together
with the risk and return of the market portfolio. The ratio of the covariance
of the individual security with the covariance of the market portfolio is
called beta. It is also called the systematic risk of a stock. Beta is the
measure of the volatility of the stock in relation to the market portfolio. Beta
is denoted by the symbol β.

Beta = COV im/σ2m

COV= Standard Deviation of the stock X Correlation X Market Standard

Deviation

Required Rate of Return = Risk-free rate + Beta (Market return-Risk free

Return)

A table of beta of the 20 stocks is given below. The beta is calculated

on the basis of the fundamental of these stocks like Standard deviation of
these stocks, correlation of the stock with market index, standard deviation
of the market returns and covariance of the market. The beta of 20 stocks
listed below is not significant. All values are less than 0.5. The stock which
possesses the highest beta in the list is only having a beta of 0.19.
The beta of the 20 scrips are listed below

Table No.7.1
Beta of the stocks1

Sl.No COMPANIES BETA

1 AXIS BANK 0.190
2 CENTURY ENKA 0.120
3 CROMPTON 0.113
4 GARWARE 0.097
5 INDIAN HOTELS 0.082
6 ESCORTS 0.075
7 ACC 0.046
8 BALLARPUR 0.046
9 GUJARAT NARMADA 0.029
10 HARRISON MALAYALAM 0.029
11 APPOLO 0.020
12 COLGATE 0.013
13 CENTURY 0.010
14 INDIAL REYONS 0.009
15 CASTROL 0.008
16 ASIAN PAINTS 0.007
17 ITC -0.005
18 ASHOK LEYLAND -0.011
19 HINDALCO -0.035
20 ARVIND -0.71

The table 7.1 above shows 20 stocks belonging to different industries

having different beta co-efficient. Stocks are listed here according to the
value of beta. The first in the list will have the highest beta. The last in the
list has least value of beta. In other words the first in the list has highest
systematic risk. The last in the list has least systematic risk when compared
to other scrips in the list. Among the scrips Axis Bank is having the highest
beta coefficient of 0.190. The systematic risk of the market is always 1. Axis
Bank has a beta less than the market portfolio. Since the systematic risk is
less than the market, the stock’s required rate of return will be less than the
market. Whatever may be the market return Axis Bank has to get beta times
the market return over and above the return for a risk-free security.
Arvind Mills was having the least value of beta coefficient. Arvind’s beta
was -0.71. It is the least value that can be seen from the table. Century Enka
is the second in the list having the highest beta next to Axis Banking.
Century Enka’s beta is 0.120. Crompton Greaves is third in having a highest
beta. The beta coefficient of Hindalco -0.035 is the least, second to Arvind
Mills..
Of the 20 companies ITC, Ashok Leyland, Arvind Mills and Hindalco
have negative betas. Negative betas are rare. Its impact is that the companies
with negative beta will get less risk-free return than the companies with
positive beta.
All stocks have beta less than 1. Betas of all stocks are insignificant
since the coefficient of them were less than 0.25.They all have less
systematic risk than the market portfolio.

Risk-Free Rate

Risk-free rate is the rate received against securities without any risk.
Generally Govt.Securities are considered as risk-free. Such securities are
also called as gilt-edged securities. Repo/Reverse repo rate is usually
reckoned as risk-free rate.

The repo/Reverse Repo rates for different periods are given below:

Table No.7.2
Repo Rate2
Year Repo
rate
1999 9
2000 11.62
2001 8.75
2002 7.75
2003 7.05
2004 6
2005 6.25
2006 6.88
2007 7.63
2008 5
2009 4.5
Average 7.31
 The above table 7.2 shows the repo rate for the 10 year period from
1999 to 2009. The average of the same is 7.31%. Average repo rate
prevailing in the country is assumed as the risk-free rate in the analysis.

REQUIRED RATE OF RETURN

RRR = RFR + B (RM-RFR)

Here,
RFR=Risk-free Rate
B= beta
RM = Market return

The required return of the 20 companies under study is calculated

below:

1. ACC
For the scrip ACC
RFR=7.31; B=.0.046;RM=0.11%
RRR = 7.31+0.046(0.11-7.31) = 6.98%

2. APOLLO
RRR = 7.31+0.02(0.11-7.31) = 7.17%

3. ARAVIND MILLS
RRR = 7.31+0.-0.71(0.11-7.31) = 0.69%
= 7.31+ -0.71+-7.2
= 7.31+ 5.11
=12.42

4. ASHOK LEYLAND
RRR = 7.31+-0.011(0.11-7.31) = 7.39

5. ASIAN PAINTS
RRR = 7.31+0.007(0.11-7.31) = 7.26%

6. BALLARPUR INDUSTRIES
RRR = 7.31+0.046(0.11-7.31) = 6.98%
7. CASTROL
RRR = 7.31+0.008(0.11-7.31) = 7.25%

8. CENTURY TEXTILES
RRR = 7.31+0.01(0.11-7.31) = 7.24%

9. CENTURY ENKA
RRR = 7.31+0.012(0.11-7.31) = 7.22%

10. COLGATE PALMOLIVE

RRR = 7.31+0.013(0.11-7.31) = 7.21%

11.CROMTON GREEVES
RRR = 7.31+0.113(0.11-7.31) = 6.5%

12. ESCORTS
RRR = 7.31+0.075(0.11-7.31) = 6.77%

13.GARWARE POLYMER
RRR = 7.31+0.097(0.11-7.31) = 6.61%

14.GUJARAT NARMADA
RRR = 7.31+0.029(0.11-7.31) = 7.10%

15.HARRISON MALAYALAM
RRR = 7.31+0.029(0.11-7.31) = 7.10%

16.HINDALCO
RRR = 7.31+ (-0.035)(0.11-7.31) = 7.56%

17.INDIAN HOTELS
RRR = 7.31+0.082(0.11-7.31) = 6.72%

18.INDIAN REYONS
RRR = 7.31+0.009(0.11-7.31) = 7.25%

19.ITC
RRR = 7.31+ (-0.005) (0.11-7.31) = 7.35%
 20.AXIS BANK
RRR = 7.31+0.190(0.11-7.31) = 5.94%

Table Showing Beta and Required Rate of Return

Table No.7.3
Beta and Required Rate of Return

NAME OF COMPANY BETA RRR(IN

PERCENT)
Aravind -0.71 12.42
Hindalco -0.035 7.50
Ashok Leyland -0.011 7.39
Itc -0.005 7.35
Asian Paints 0.007 7.26
Castrol 0.008 7.25
Indian Reyons 0.009 7.25
Century 0.010 7.24
Century Enka 0.120 7.22
Colgate 0.013 7.21
Appolo 0.020 7.17
Gujarat Narmada 0.029 7.10
Harrison Malayalam 0.029 7.10
Acc 0.046 6.98
Ballarpur 0.046 6.98
Escorts 0.075 6.77
Indian Hotels 0.082 6.72
Garware 0.097 6.61
Crompton 0.113 6.5
Axis Bank 0.190 5.94

The above table 7.3 shows the relationship between beta and required
rate of return of a risky asset. As stated above, beta can be viewed as a
standard measure of systematic risk. If the beta of a stock is 1 then its risk is
equal to market risk. The implication is that in case the market return
increases by 10% the stock’s return will also increase by 10%. On the
contrary for a 10% fall in the market return the stock’s return will also
reduce by 10%. If the beta is 0.5 the security’s risk will be 0.5 of the market
risk. If the return on market portfolio is prospering, the individual stock will
get beta times of that prosperity.
For the period 1999-2009 the market return was assessed as 0.11%.
The risk-free rate for the same period was presumed as 7.31%. The RRF IS
greater than the market portfolio’s return (RRF>RM). The market for the
period was highly depressed. The market was incurring heavy losses (loss=
0.11-7.31=-7.2). If the beta of an individual stock is 1 it has to lose the
whole 7.2%. The lower the beta lower will be the loss. The market portfolio
had been suffering greater losses. The individual securities with higher beta
would have to get the shock of this market depression. Accordingly the beta
of a stock and the required rate return are related. The table above gives the
beta of 20 scrips and their respective required rate of returns under this
condition.
As per the table, Under condition of market loss Axis Bank with
highest beta has lowest required rate return. Refer table above. Similarly,
Arvind Mills with lowest beta has highest required rate of return. From the
table it can be understood that the stocks with relatively higher beta have
lower RRR and stocks with relatively lower beta have higher RRR.

1. ACC

ACC had a beta of 0.046. So it had to bear 0.046 times the market loss
of 7.2 since the market was losing. 0.046 times of 7.2 would come to 0.33.
So the required return is (7.31(RRF)-0.33) 6.98%.

2. APOLLO TYRES

In the case Apollo Tyres the beta was 0.020. Apollo’s beta is lower
than ACC. Therefore the impact of market loss on Apollo will be less than
ACC. So the RRR of Apollo is greater than ACC. Apollo ‘s RRR is
calculated and given in the table as 7.17%. In times of losses lower the beta
higher the return maxim will prevail. 7.17>6.98.

3. ARVIND MILLS

In the case of Arvind Mills, the beta calculated was -0.71. The beta is
the lowest of all. Since the beta of Arvind Mills is negative its impact will be
opposite to the stocks having positive beta. Negative beta means the inverse
comovement of the stock in relation to the market. Hence, when the market
is dull, the stock’s RRR will increase. in the table the RRR is worked out at
12.42%.

4. ASHOK LEYLAND

Ashok Leyland is also having negative beta. Its comovement with the
market is inverse. If the market goes up Ashok will come down.Now the
market has low return and its return is lower than the risk-free return. Hence
the RRR of the stock would go up. In the table above Ashok Leyland’s RRR
is given as 7.39%.

5. ASIAN PAINTS

Asian paints had lower beta when compared to other companies in the
list. Its beta is 0.007. It need bear only lower amount of the market loss.
Therefore its RRR is equal to 7.26%.

6. BALLARPUR INDUSTRIES

In the case of Ballarpur Industries, the beta is identical to ACC. That

is 0.046. Therefore its RRR is (0.046 times the market loss of -7.2)-RFR
7.31=6.98%.

7. CASTROL

In the case of Castrol the beta is 0.008. Castrol’s beta is lower.

Therefore it need share only 0.008 portion of the market loss of 7.2%. Hence
the RRR IS 7.25%.

8. CENTURY TEXTILES

In the case of Century the beta is 0.010. Century’s beta is lower than
Ballarpur but more than Castrol. Therefore Century’s RRR is 7.24. That is
(0.01* -7.2) -7.31
 9. CENTURY ENKA

Century Enka’s beta is 0.012 which is higher than Cenutry. Therefore

its required return will be less than Century. It can be seen from the table.
RRR is shown as 7.22

10. COLGATE PALMOLIVE

Colgate Palmolive has a beta of 0.013 which is century Enkka.

Colgate Palmolive’s systematic risk is more than that of Century Enka and
Century. Therefore its RRR under conditions of market loss will be less. The
table shows the RRR of Colgate Palmolive as 7.21(7.21<7.22<7.31)

11. CROMPTON GREAVES

In the case of Crompton, beta is given as 0.113. Crompton has a beta

higher than Colgate,Century Enka, Century and that of Castrol. Since the
market will be losing the risk of Crompton will be more due to its higher
beta. The RRR is given in the table as 6.5. It can be seen that the RRR of
Crompton is lower than Colgate Palmolive, Century Enka or Century.

12.ESCORTS LTD

In the case of Escorts, beta is 0.075 which is lower than Crompton and
higher than Colgate Palmolive. Accordingly the calculated RRR is given in
the table as 6.77%. It can be seen that it is higher than Crompton but less
than Colgate Palmolive.

13.GARWARE POLYESTER

In the case of Garware Polyester, the beta is 0.097 which is higher

than escort’s beta but lower than Crompton. Accordingly the RRR of
Garware Polyester is given in the table as 6.61%. It can be seen from the
table that RRR 6.61<RRR of Escorts>RRR of Crompton that is Garware
Polyester’s RRR is less than the RRR of Escorts but more than Crompton.
 14.GUJARATH NARMADA

Gujarat Narmada has a beta of 0.029 which is lower than Garware

polyester’s 0.097 and Escorts 0.075. Therefore the RRR of it will be
relatively higher. The table gives the RRR of Gujjarat Narmada as 7.1 which
is more than that of Garware Polyester and Escorts.

15.HARRISONS MALAYALAM

Harrisons Malayalam has a beta of 0.029 like Gujarat Narmamda. Its

RRR is given in the table as 7.1.

16.HINDALCO

Hindalco’s beta is given in the table as -0.035. A negative beta is

rare. The beta is negligible. The covariance of the scrip is in the opposite
direction. Therefore as a matter of principle, the stock has to get more return.
Its required rate of return should be different from other scrips with positive
beta. In the table the RRR is given as 7.5% which is higher than RFR 7.31%.
Hindalco gets not only the risk-free rate, in addition to it, some extra to
constitute 7.5%. It is due to the negative covariance of the scrip vis-à-vis the
market portfolio. The RRR of Hindalco is more when compared to other
stocks under study. It can be seen from the table. The contrast to note is that
the RRR of Axis bank whose beta is highest is the lowest and the RRR of
Hindalco whose beta is lower is the higher under conditions of market loss.

17.INDIAN HOTELS

In the case of Indian Hotels, the beta is given as 0.082 which is higher
than Hindalco. So the RRR will be less than Hindalco. The table shows that
the RRR Indian Hotels as 6.72. It can be seen that the RRR of Indian Hotels
is less than the RRR of Hindalco.

18.INDIAN REYONS

Indian Reyons has a beta of 0.009 which is lower than Indian Hotels.
So its RRR will be more than Indian hotels. Table value of RRR is 7.25%.
 19.ITC LTD

ITC Ltd too has negative beta of -0.005. Rarity of negative beta needs
special attention. Though the beta ITC Ltd is negative it last but one in the
list. Its systematic risk is lowest next to Hindalco. The beta of ITC Ltd is
more than Hindalco. Hence its RRR will be less than Hindalco. The table
gives the RRR as 7.35%.

20.AXIS BANK

Axis bank has a beta of 0.190 which is highest as per the table.
Therefore the RRR of Axis Bank ought to be less than ITC Ltd. The table
gives the value of RRR as 5.94.

In this way the RRR and the beta are related. The lower the beta a
company has the higher the required rate of return in times market losses. In
times of market gains, the reverse will be true.
Table No.7.4
Comparison of HPY, RRR and Alpha

COMPANIES HPY RRR EXCESS V/UV

ACC 13 6.98 6.02 Undervalued
APPOLO 24.64 7.17 17.47 Undervalued
ARAVIND 14.45 0.69 13.76 Undervalued
ASHOK LEYLAND 48.27 7.39 40.88 Undervalued
ASIAN PAINTS 23.27 7.26 16.01 Undervalued
BALLARPUR 16.64 6.98 9.66 Undervalued
CASTROL 4.82 7.25 -2.43 Overvalued
CENTURY 53 7.24 45.76 Undervalued
CENTURY ENKA 51.82 7.22 44.6 Undervalued
COLGATE 12.91 7.21 5.7 Undervalued
CROMPTON 61.91 6.5 55.41 Undervalued
ESCORTS 25.73 6.77 18.96 Undervalued
GARWARE 62.73 6.61 56.12 Undervalued
GUJARAT NARMADA 37.82 7.10 30.72 Undervalued
HARRISON 51.91 7.10 44.81 Undervalued
MALAYALAM
HINDALCO 21.27 7.50 13.77 Undervalued
COMPANIES HPY RRR EXCESS V/UV
INDIAN HOTELS 14.00 6.72 7.28 Undervalued
INDIAL REYONS 36.82 7.25 29,57 Undervalued
ITC 4.27 7.35 -3.08 Overvalued
AXIS BANK 60.09 5.94 54.15 Undervalued

The above table shows the relationship between the HPY and RRR. In
the first column Name of the companies is marked. In the second column
Holding Period Yield(HPY) is marked. In the third column Excess is marked
and in the fourth column whether the stock is undervalued or overvalued or
properly valued is stated.

Holding Period Yield. (HPY)

Companies will have an estimation of possible estimation about the

future returns based on their past years performances. It is the Holding
Period Yield(HPY). It can also be called as estimated returns of a company.
In the table above ACC’s HPY is given as 13%. It means that investors
expect 13% return from the stock ACC in the future.

Required Rate of Return (RRR)

It is the return expected by the holders of risky assets in relation to the

market portfolio. RRR is determined by the Risk-free rate, beta coefficient
of the asset and market return. It is calculated by using the CAPM (Capital
Asset Pricing Model). RRR and HPY are different. Under conditions of
equilibrium RRR should be equal to estimated return (HPY). Due to market
imperfection assets were mispriced.

Excess (Alpha)

Equilibrium is a golden assumption which seldom fulfills in the real

market. There will be difference between the Expected return and the
required rate of return. This difference is called Excess. It is also called as
alpha.
If the estimated return is greater than the RRR, the excess will be
positive and the asset is said to be undervalued. On the contrary if the
estimated return or HPY is lower than the RRR the asset is considered to be
overvalued. In this case the alpha will be negative. If the estimated return is
equal to RRR the asset is properly valued.

As a market strategy the undervalued shares will be bought from the

market and overvalued stocks will be immediately disposed or will be used
for short selling. Nothing will be done if the asset is properly.

In the table ACC‘s Estimated return is 13%. Required Rate of Return

is 6.98. The estimated return or HPY is in excess over the RRR to the extent
of 6.02. ACC is undervalued.

Apollo‘s HPY is 24.64. RRR7.1. There is an excess of 17.47. HPY is

excess over RRR. Apollo is undervalued

Ashok Leyland’s estimated return 48.27 is in excess over its RRR

7.39. The excess or alpha is positive 40.88. It is undervalued.

Asian paints is undervalued to the extent of positive 16.1.

Ballarpur Industries HPY is 16.64. Its RRR is 6.98. There is an excess

of 9.66 positive. The asset is undervalued.

Castrol’s estimated return is 4.82. RRR is 7.25. The difference

between the two is negative. The estimated return is less than the RRR. The
alpha is negative. The asset is overvalued. Asset is overvalued in the sense
that the required rate of return under conditions of market risk is more than
the estimated return from the stock. Assessing RRR is equal to pricing of the
asset.

Century Textiles’s estimated return is 53. Its RRR is 7.24.There is an

excess of 45.76. Therefore the asset is undervalued.

The estimated return of Century Enka is 51.82. Its RRR is 7.22. There
is a deficit of 44.6. The scrip is undervalued.

Colgate Palmolive is undervalued to the extent of 5.7.

Similarly Crompton, escorts, Garware Polyester, Gujrat narmada,

Harrison Malayalam, Hindalco, Indian Hotels, and Indian Reyons are
undervalued.
ITC Ltd has a negative alpha to the extent of 3.08. It is overvalued.
Axis Bank is undervalued.

Source:

1. Official website of Bombay Stock Exchange

2. Official website of Reserve Bank of India