What is beta and how much weight should one give to it?

We've written before about how beta is derived and its main application, so I won't go into too much detail here about what beta is. I'll spend more time discussing how much weight we believe one should give it.

What Beta Is
Suffice it to say that beta is a measure of relative volatility. By definition, the market has a beta of 1.0, and individual stocks are ranked according to their variance from the market. If a stock bounces up and down more than the market does over time (as Yahoo (NasdaqNM:YHOO - News) has, for example), its beta will be above 1.0. If a stock bounces less than the market (like Johnson & Johnson (NYSE:JNJ - News)), its beta will be below 1.0. Note that beta is not a measure of an asset's returns relative to the market, but only its volatility.

As a proxy for risk, beta is a key component for the Capital Asset Pricing Model (CAPM), which many investors use to calculate a firm's cost of equity. This number is critical, because it's the rate at which future cash flows are discounted to the present. These cash flows are the essence of a company's worth, so beta can have a big impact on stock price.

What's Beta Worth?
There are a lot of strong opinions out there about beta. To devotees of Modern Portfolio Theory, the longtime guiding light of financial academia, beta is a measure of a stock's sensitivity to macroeconomic events relative to the overall stock market, and this volatility is important to consider when one is building a portfolio with optimum risk levels. To fundamental investors who strongly object to the notion of an efficient market, beta is just a pile of noise that has nothing to do with future cash flows, and should not therefore influence any estimate of value.

Berkshire Hathaway (brk.b.B) chairman Warren Buffett derides the concept, because it implies that a stock that has fallen sharply in value is ipso facto more risky than it was before it fell. He uses the example of Washington Post (NYSE:WPO - News), which plummeted 1973 just before Berkshire bought it. Buffett believed that the company was a substantially less risky investment after the fall, because he was getting the same great company at a better price, despite the rise in its beta following its decline. (In his Ruminations on Risk, Michael Mauboussin points out that Buffett's attack on beta is misguided--the stock's beta did not rise, and would not have necessarily in this situation--although he supports Buffett's view that beta is not the most useful way to think about risk.)

Advantages of Beta
Beta certainly has some things going for it. First, it's quantifiable, which makes it easy to work with and to communicate. There are variations, depending on such things as the market index used and the time period measured, but the general concept is easy to grasp. Second, it provides a generally defensible cost of equity that serves the purpose of a valuation model. It's just one input, after all, and any search for a better one detracts from the valuation task at hand. Third, as valuation guru Aswath Damodaran points out, alternative models haven't convincingly shown any greater ability to predict expected returns, which is ultimately what we're after.

Disadvantages of Beta
Beta has some mechanical drawbacks--for example, a few stocks can dominate the market index--but there are two key conceptual problems. First, beta doesn't incorporate new information. Duke Energy (NYSE:DUK - News), for example, was a staid utility with a low beta, but when it got into the merchant energy business, its old beta didn't capture the new risks. Second, it doesn't apply equally over all time periods. For investors with short holding periods, beta is a good measure of risk, because fluctuations put value at risk in holding periods of less than a few years. For long-term investors such as Buffett, however, fluctuations in stock price are less relevant. "In fact," as Buffett has said, "the true investor welcomes volatility.... The more manic-depressive [the market is], the greater the opportunities available to the investor."

Bottom Line
This last point is the bottom line for Morningstar: Because we advise investors to think like long-term owners of a company rather than short-term traders of stock, we fall squarely on the Buffett end of the spectrum. We don't use beta to determine our costs of equity, or anything else for that matter. Instead, we use a cost of equity derived from fundamental inputs that affect a company's business, such as its debt load, profitability, corporate governance, and the cyclicality of its industry. We also incorporate risk into our star ratings by demanding a margin of safety to our fair value estimate--as Buffett does--the degree of which is determined by our analysts' estimation of the firm's risks and competitive advantages.

Share-price volatility may mean risk over the near term, but for those looking further out it can mean opportunity.