Impacts of Stock’s Beta on Rate of Return
The Beta for FLIR Systems Joey Moss, a recent finance graduate, has just begun his job with the investment firm of Covili and Wyatt. Janet Covili, one of the firm’s founders, has been talking to Joey about the firm’s investment portfolio. As with any investment, Janet is concerned about the risk of the investment as well as the potential return. More specifically, because the company holds a diversified portfolio, Janet is concerned about the systematic risk of current and potential investments. One position the company currently holds is stock in FLIR Systems, Inc. (FLIR). FLIR Systems designs, manufactures, and markets thermal imaging and infrared camera systems. Although better known for its military applications, the company has divisions that design products for other applications such as automotive night vision, commercial products that require minute temperature difference measurements, recreational marine usage, and firefighting. Covili and Wyatt currently uses a commercial data vendor for information about its positions. Because of this, Janet is unsure exactly how the numbers provided are cal The data provider considers its methods proprietary, and it will not disclose how stock betas and other information are calculated. Janet is uncomfortable with not knowing exactly how these numbers are being computed and also believes that it could be less expensive to calculate the necessary statistics in-house. To explore this question, Janet has asked Joey to do the following assignments:
Question: How does a stock’s beta impact its expected rate of return and share valuation for FLIR Systems?
Beta is a measure of a stock’s sensitivity to market movements. It indicates how much a stock’s price is expected to move in relation to the overall market. A beta of 1 means the stock will move in line with the market, while a beta greater than 1 suggests the stock will be more volatile, and a beta less than 1 indicates lower volatility compared to the market.
The impact of a stock’s beta on its expected rate of return and share valuation for FLIR Systems depends on the specific circumstances and the investor’s perspective. Here are a few general points to consider:
- Expected Rate of Return: A stock’s beta is often used as a factor in estimating its expected rate of return. In the context of the Capital Asset Pricing Model (CAPM), the expected return of a stock is calculated by adding a risk premium to the risk-free rate of return. The risk premium is determined by multiplying the market risk premium (the excess return expected from the market as a whole) by the stock’s beta. Therefore, a higher beta generally implies a higher expected rate of return, as the stock is considered riskier and should provide greater potential rewards.
- Share Valuation: Beta can also affect share valuation. In valuation models like the discounted cash flow (DCF) analysis or the dividend discount model (DDM), the cost of equity capital is a crucial input. The cost of equity reflects the return required by investors to compensate for the stock’s risk. Beta is often used to estimate the stock’s systematic risk, which is an integral part of determining the cost of equity. A higher beta leads to a higher cost of equity and, subsequently, a lower valuation for the stock, all else being equal. Conversely, a lower beta results in a lower cost of equity and potentially a higher valuation.
It is important to note that beta is not the sole determinant of a stock’s expected return or valuation. Other factors, such as the company’s financial performance, growth prospects, competitive landscape, and macroeconomic conditions, also play significant roles. Furthermore, beta is based on historical data and may not accurately predict future stock price movements.
