What is the CAPM beta? How is it different from Cash Flow beta?
What is the CAPM beta? How is it different from Cash Flow beta?Provide intuitive explanation and formulae for both.
CAPM beta
Beta is an important component of the CAPM- capital asset pricing model, which calculates the cost of equity funding.
Firm’s beta measures stock's volatility in relation to the overall market. Beta above 1.0 shows that a stock swings more than the market over time, while if a stock moves less than the market, the stock's beta is less than 1.0. Riskier stocks have high beta but provide higher return potential; low-beta stocks have less risk with lower returns. Firm’s beta is affected by operating and financial leverage, company's debt level, business cycle, and capital structure. For example, if a company increases its debt i.e. beta of levered stock is greater than 1, then firm's stock has higher volatility.
Beta coefficient determines the risk factors of the security market line (SML). Beta of firm’s measures the stock's volatility in line with the overall market scenario.
Beta formula= Covariance (Re, Rm) /Variance (Rm)
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Cash Flow beta
The cash flow beta represents the exposure of value of equity to changes in cash flows for the broad equity market, while the discount rate beta reflects the exposure of equity value to changes in discount rates for the market.
Beta= Covariance(rI, NCF, T)/ Variance(NCF,t-NDR,T)
rI= returns on individual stock. NCF, T and NDR,T represents news about cash flow, and discount rate.
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