Monday, September 26, 2011

EMFPS: How Can We Obtain the “Beta” to Analyze CAPM?


We need to CAPM analysis not only to evaluate the risk of company’s assets portfolio but also to assess the feasibility of the projects by using of capital budgeting method. As you know, the formula of Capital Asset Pricing Model (CAPM) is as follow:
CAPM = Rf + [B * (Rm – Rf)]
In this article, I am willing to expand my debate on “B”.
At the first, we should divide the companies in two groups:
                      ·                      Private companies: Where the expected return of the company has been calculated in accordance with EBITDA multiplier’s method.
                      ·                      Public companies: Where the expected return of the company has been calculated in accordance with the share price.
Here, I am willing to depict the Beta of public companies. Then I will bring you an example as the practice and finally I will compare the market return of a Stock Index with historic market return of the world in which the result will be referred to the Economic Systems.
Before everything, we should clear our target as follows:
1) Do we want to anticipate the Beta for next several years?
2) Do we want to calculate the Beta by using of historical information? In this case, we should classify the companies in accordance with their dividend policy as follows:
Ø  The company has paid the dividend in the period of our limited time.
Ø  The company has not paid any dividend in the period of our limited time.
If we are expected to anticipate “B” for next several years, we should use from behavioral approach for instance, simulation method such as the Monte Carlo simulation programs in which we have to define several possible alternative outcomes just like to Scenario Analysis and then we should try to determine probability distribution and random numbers to estimate the percentage of probability which is matched to each required return and market return for each one of the outcomes. For example, we can extract some economic data forecasts from IMF (International Monetary Fund) such as GDP Growth (Constant Prices, National Currency) for revenue growth, Inflation (Average Consumer Price Change %) for COGS, Unemployment Rate (% of Labour Force) and government interest rate for Selling and Administrative Expenses and so on. Then we need to build an Excel spreadsheet such as Kimi Ford’s sensitivity analysis included in Exhibit (2) of Case analysis of Nike, Inc: Cost of Capital (see the link of http://emfps.blogspot.com/2011/06/case-analysis-of-nike-inc-cost-of.html). Finally we will obtain something like below example by using of the Monte Carlo simulation program:


Assume we want to calculate the Beta of Company “M” for the period of next ten years. According to above mentioned, we have obtained below data:
Outcomes of the Economy  Probability  Market Return  Company’s Return
  Stagnant                                  15%                    7%                        9%
  Slow growth                            25%                    11%                     13%
  Medium growth                       30%                    14%                     18%
  Rapid growth                          30 %                    21%                     27%
Now, we are able to calculate the expected return of Market and Company by multiplying the percentage of probability by them as follows:
Expected return of Market = SUM [(probability)*(Market Return)] = 14.30 %
Expected return of Company = SUM [(probability)*(Company’s Return)] = 18.10 %
Regarding to the formula of the Beta, we have:
B = Cov (ra, rm) / Qm^2
Where:
Cov (ra, rm) = SUM [(probability) * (Market return - Expected return of Market) * (Company's return -Expected return of Company)]
Qm^2 = variance of the return on the market portfolio = SUM [(probability)* ((Market return - Expected return of Market)^2)]
Cov (ra, rm) = 0.003207
Qm^2 = 0.00242
B = 0.003207 / 0.00242 = 1.325
Now, let us focus on historical data to analyze the Beta of Company “M”. In this case, we do not need to have any probability distribution because all events have been already occurred and we can consider the related probabilities to be equal. Therefore, the expected return is the same the average of Company’s returns during the period of our chosen time.
The method of the Beta analysis will be done step by step as follows:
-Go to one of the financial websites such as: http://finance.yahoo.com
-On “GET QUOTES” search the name of your chosen Company
-Click on “Historical prices”
-I usually search for monthly but you can also search daily or weekly (you should remember that finally the return rate should be changed to annually).
-Copy and Paste all data on your Excel spreadsheet
- On “GET QUOTES” search the related Stock Index of the company to obtain the market return
-Click on “Historical prices”
-Search your chosen time just like to the time extracted for the company
-Copy and Paste all data on your Excel spreadsheet
To be continued …….

Note:  “All spreadsheets and calculation notes are available. The people, who are interested in having my spreadsheets of this method as a template for further practice, do not hesitate to ask me by sending an email to: soleimani_gh@hotmail.com or call me on my cellphone: +989109250225.   Please be informed these spreadsheets are not free of charge.”