Shall We Throw the Beta Out?
Aug 09, 2005
In June 1992 Eugene Fama and Ken French of the University of Chicago published a paper in The Journal of Finance that created stirred a hornet's nest in the Finance academia as well as on Wall Street. In their celebrated paper they practically pronounced Beta, the measure of systematic risk of equities, dead.
In fact, they were not alone in their pronouncement of the death of beta. A long list of academicians had questioned the usefulness of beat in explaining the risk premium of equities before them. But Fama and French's paper was the most decisive and blow to the foundations of the Capital Asset Pricing Model (CAPM). Their research concluded that the average stock returns are not positively related to the market betas. On the contrary, they found that the equity returns are inversely related to the size of the company measured by the value of its equity capitalization and positively related to the the ratio of the book value of the company's equity to its market value. When all these parameters were input in the model, beta added nothing extra to an analyst's ability to explain (forecast) equity returns.
By the way, most analysts and fund managers the world over still swear by the beta.
(Reference: Measuring and Managing the Value of Companies by Copeland, Koller and Murrin (McKinsey & Company)).
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