Chapter Seven

BETA ANALYSIS OF EQUITY RETURNSANALYSIS III

Chapter Seven

BETA ANALYSIS OF EQUITY RETURNSANALYSIS III

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

When a stock belonging to a particular risk class is purchased theinvestor expects return on it commensurate with its risk. The greater the riskof the stock the greater will be the expected rate of return. The rate expectedby the investor on his investment in a stock in relation to market risk is therequired rate of return. Individual Stock’s return and risk move togetherwith the risk and return of the market portfolio. The ratio of the covarianceof the individual security with the covariance of the market portfolio iscalled beta. It is also called the systematic risk of a stock. Beta is themeasure of the volatility of the stock in relation to the market portfolio. Betais denoted by the symbol β.

Beta = COV im/σ2m

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

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

A table of beta of the 20 stocks is given below. The beta is calculatedon the basis of the fundamental of these stocks like Standard deviation ofthese stocks, correlation of the stock with market index, standard deviationof the market returns and covariance of the market. The beta of 20 stockslisted below is not significant. All values are less than 0.5. The stock whichpossesses 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.7.1Beta of the stocks1

The table 7.1 above shows 20 stocks belonging to different industrieshaving different beta co-efficient. Stocks are listed here according to thevalue of beta. The first in the list will have the highest beta. The last in thelist has least value of beta. In other words the first in the list has highestsystematic risk. The last in the list has least systematic risk when comparedto other scrips in the list. Among the scrips Axis Bank is having the highestbeta coefficient of 0.190. The systematic risk of the market is always 1. AxisBank has a beta less than the market portfolio. Since the systematic risk isless than the market, the stock’s required rate of return will be less than themarket. Whatever may be the market return Axis Bank has to get beta timesthe market return over and above the return for a risk-free security.

Sl.No COMPANIES BETA1 AXIS BANK 0.1902 CENTURY ENKA 0.1203 CROMPTON 0.1134 GARWARE 0.0975 INDIAN HOTELS 0.0826 ESCORTS 0.0757 ACC 0.0468 BALLARPUR 0.0469 GUJARAT NARMADA 0.02910 HARRISON MALAYALAM 0.02911 APPOLO 0.02012 COLGATE 0.01313 CENTURY 0.01014 INDIAL REYONS 0.00915 CASTROL 0.00816 ASIAN PAINTS 0.00717 ITC -0.00518 ASHOK LEYLAND -0.01119 HINDALCO -0.03520 ARVIND -0.71

Arvind Mills was having the least value of beta coefficient. Arvind’s betawas -0.71. It is the least value that can be seen from the table. Century Enkais 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 highestbeta. The beta coefficient of Hindalco -0.035 is the least, second to ArvindMills..

Of the 20 companies ITC, Ashok Leyland, Arvind Mills and Hindalcohave negative betas. Negative betas are rare. Its impact is that the companieswith negative beta will get less risk-free return than the companies withpositive beta.

All stocks have beta less than 1. Betas of all stocks are insignificantsince the coefficient of them were less than 0.25.They all have lesssystematic 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 arealso called as gilt-edged securities. Repo/Reverse repo rate is usuallyreckoned as risk-free rate.

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

Table No.7.2Repo Rate2

Year Reporate

1999 92000 11.622001 8.752002 7.752003 7.052004 62005 6.252006 6.882007 7.632008 52009 4.5

Average 7.31

The above table 7.2 shows the repo rate for the 10 year period from1999 to 2009. The average of the same is 7.31%. Average repo rateprevailing 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 RateB= betaRM = Market return

The required return of the 20 companies under study is calculatedbelow:

1. ACCFor the scrip ACCRFR=7.31; B=.0.046;RM=0.11%

RRR = 7.31+0.046(0.11-7.31) = 6.98%

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

3. ARAVIND MILLSRRR = 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 LEYLANDRRR = 7.31+-0.011(0.11-7.31) = 7.39

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

6. BALLARPUR INDUSTRIESRRR = 7.31+0.046(0.11-7.31) = 6.98%

7. CASTROLRRR = 7.31+0.008(0.11-7.31) = 7.25%

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

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

10. COLGATE PALMOLIVERRR = 7.31+0.013(0.11-7.31) = 7.21%

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

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

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

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

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

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

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

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

19.ITCRRR = 7.31+ (-0.005) (0.11-7.31) = 7.35%

20.AXIS BANKRRR = 7.31+0.190(0.11-7.31) = 5.94%

Table Showing Beta and Required Rate of Return

Table No.7.3Beta and Required Rate of Return

NAME OF COMPANY BETA RRR(INPERCENT)

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

The above table 7.3 shows the relationship between beta and requiredrate of return of a risky asset. As stated above, beta can be viewed as astandard measure of systematic risk. If the beta of a stock is 1 then its risk isequal to market risk. The implication is that in case the market returnincreases 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 alsoreduce by 10%. If the beta is 0.5 the security’s risk will be 0.5 of the marketrisk. If the return on market portfolio is prospering, the individual stock willget 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 ISgreater than the market portfolio’s return (RRF>RM). The market for theperiod 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 thewhole 7.2%. The lower the beta lower will be the loss. The market portfoliohad been suffering greater losses. The individual securities with higher betawould have to get the shock of this market depression. Accordingly the betaof a stock and the required rate return are related. The table above gives thebeta of 20 scrips and their respective required rate of returns under thiscondition.

As per the table, Under condition of market loss Axis Bank withhighest beta has lowest required rate return. Refer table above. Similarly,Arvind Mills with lowest beta has highest required rate of return. From thetable it can be understood that the stocks with relatively higher beta havelower 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 lossof 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 lowerthan ACC. Therefore the impact of market loss on Apollo will be less thanACC. So the RRR of Apollo is greater than ACC. Apollo ‘s RRR iscalculated and given in the table as 7.17%. In times of losses lower the betahigher 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 isthe lowest of all. Since the beta of Arvind Mills is negative its impact will beopposite to the stocks having positive beta. Negative beta means the inverse

comovement of the stock in relation to the market. Hence, when the marketis dull, the stock’s RRR will increase. in the table the RRR is worked out at12.42%.

4. ASHOK LEYLAND

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

5. ASIAN PAINTS

Asian paints had lower beta when compared to other companies in thelist. 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. Thatis 0.046. Therefore its RRR is (0.046 times the market loss of -7.2)-RFR7.31=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%. Hencethe RRR IS 7.25%.

8. CENTURY TEXTILES

In the case of Century the beta is 0.010. Century’s beta is lower thanBallarpur 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. Thereforeits 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 andCentury. Therefore its RRR under conditions of market loss will be less. Thetable 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 betahigher than Colgate,Century Enka, Century and that of Castrol. Since themarket will be losing the risk of Crompton will be more due to its higherbeta. The RRR is given in the table as 6.5. It can be seen that the RRR ofCrompton 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 andhigher than Colgate Palmolive. Accordingly the calculated RRR is given inthe table as 6.77%. It can be seen that it is higher than Crompton but lessthan Colgate Palmolive.

13.GARWARE POLYESTER

In the case of Garware Polyester, the beta is 0.097 which is higherthan escort’s beta but lower than Crompton. Accordingly the RRR ofGarware Polyester is given in the table as 6.61%. It can be seen from thetable that RRR 6.61<RRR of Escorts>RRR of Crompton that is GarwarePolyester’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 Garwarepolyester’s 0.097 and Escorts 0.075. Therefore the RRR of it will berelatively higher. The table gives the RRR of Gujjarat Narmada as 7.1 whichis more than that of Garware Polyester and Escorts.

15.HARRISONS MALAYALAM

Harrisons Malayalam has a beta of 0.029 like Gujarat Narmamda. ItsRRR is given in the table as 7.1.

16.HINDALCO

Hindalco’s beta is given in the table as -0.035. A negative beta israre. The beta is negligible. The covariance of the scrip is in the oppositedirection. 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 positivebeta. 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 toconstitute 7.5%. It is due to the negative covariance of the scrip vis-à-vis themarket portfolio. The RRR of Hindalco is more when compared to otherstocks under study. It can be seen from the table. The contrast to note is thatthe RRR of Axis bank whose beta is highest is the lowest and the RRR ofHindalco 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 higherthan Hindalco. So the RRR will be less than Hindalco. The table shows thatthe RRR Indian Hotels as 6.72. It can be seen that the RRR of Indian Hotelsis 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 needsspecial attention. Though the beta ITC Ltd is negative it last but one in thelist. Its systematic risk is lowest next to Hindalco. The beta of ITC Ltd ismore than Hindalco. Hence its RRR will be less than Hindalco. The tablegives 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 tablegives the value of RRR as 5.94.

In this way the RRR and the beta are related. The lower the beta acompany has the higher the required rate of return in times market losses. Intimes of market gains, the reverse will be true.

Table No.7.4Comparison of HPY, RRR and Alpha

COMPANIES HPY RRR EXCESS V/UVACC 13 6.98 6.02 UndervaluedAPPOLO 24.64 7.17 17.47 UndervaluedARAVIND 14.45 0.69 13.76 UndervaluedASHOK LEYLAND 48.27 7.39 40.88 UndervaluedASIAN PAINTS 23.27 7.26 16.01 UndervaluedBALLARPUR 16.64 6.98 9.66 UndervaluedCASTROL 4.82 7.25 -2.43 OvervaluedCENTURY 53 7.24 45.76 UndervaluedCENTURY ENKA 51.82 7.22 44.6 UndervaluedCOLGATE 12.91 7.21 5.7 UndervaluedCROMPTON 61.91 6.5 55.41 UndervaluedESCORTS 25.73 6.77 18.96 UndervaluedGARWARE 62.73 6.61 56.12 UndervaluedGUJARAT NARMADA 37.82 7.10 30.72 UndervaluedHARRISONMALAYALAM

51.91 7.10 44.81 Undervalued

HINDALCO 21.27 7.50 13.77 Undervalued

COMPANIES HPY RRR EXCESS V/UVINDIAN HOTELS 14.00 6.72 7.28 UndervaluedINDIAL REYONS 36.82 7.25 29,57 UndervaluedITC 4.27 7.35 -3.08 OvervaluedAXIS BANK 60.09 5.94 54.15 Undervalued

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

Holding Period Yield. (HPY)

Companies will have an estimation of possible estimation about thefuture returns based on their past years performances. It is the HoldingPeriod 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 investorsexpect 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 themarket portfolio. RRR is determined by the Risk-free rate, beta coefficientof the asset and market return. It is calculated by using the CAPM (CapitalAsset Pricing Model). RRR and HPY are different. Under conditions ofequilibrium RRR should be equal to estimated return (HPY). Due to marketimperfection assets were mispriced.

Excess (Alpha)

Equilibrium is a golden assumption which seldom fulfills in the realmarket. There will be difference between the Expected return and therequired rate of return. This difference is called Excess. It is also called asalpha.

If the estimated return is greater than the RRR, the excess will bepositive and the asset is said to be undervalued. On the contrary if theestimated 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 isequal to RRR the asset is properly valued.

As a market strategy the undervalued shares will be bought from themarket and overvalued stocks will be immediately disposed or will be usedfor short selling. Nothing will be done if the asset is properly.

In the table ACC‘s Estimated return is 13%. Required Rate of Returnis 6.98. The estimated return or HPY is in excess over the RRR to the extentof 6.02. ACC is undervalued.

Apollo‘s HPY is 24.64. RRR7.1. There is an excess of 17.47. HPY isexcess over RRR. Apollo is undervalued

Ashok Leyland’s estimated return 48.27 is in excess over its RRR7.39. 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 excessof 9.66 positive. The asset is undervalued.

Castrol’s estimated return is 4.82. RRR is 7.25. The differencebetween the two is negative. The estimated return is less than the RRR. Thealpha is negative. The asset is overvalued. Asset is overvalued in the sensethat the required rate of return under conditions of market risk is more thanthe estimated return from the stock. Assessing RRR is equal to pricing of theasset.

Century Textiles’s estimated return is 53. Its RRR is 7.24.There is anexcess of 45.76. Therefore the asset is undervalued.

The estimated return of Century Enka is 51.82. Its RRR is 7.22. Thereis 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 areundervalued.

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 Exchange2. Official website of Reserve Bank of India