FORWARD BETA THAT INCLUDES MARKET
AND STOCK FUNDAMENTALS
Susheel Narula 1
susheeln@gmail.com,
December 2023
ABSTRACT
Beta is an important variable used as an input in determining a discount rate (or a required
return) to calculate the fair value of equity. Efforts have been made to improve the quality of
Beta’s estimate beyond the typical approach of regressing past prices by including company
fundamental factors. This paper looks at Beta as a function that finds equilibrium between
outlook of company fundamentals and market dynamics; its derivation lies somewhere
between the domains of equity analysts and market strategists. Sample of work includes both
developed and developing markets.
KEY WORDS
Beta, CAMP, Discount Rate, WACC, Equity Risk Premium, Market Risk Premium, Valuation,
Developing Market
INTRODUCTION
Required Returns on Equity or Weighted Average Cost of Capital (WACC), derived from the
Capital Asset Pricing Model (CAPM), is widely used as a discount rate to discount streams of
cashflows in order to arrive at an equity value. (This paper will restrict the discussions to equity
asset class only.) Critically, every variable that goes into the valuation process is ‘forward-
looking’, with the typical exception of Beta which generally is derived from historical stock
prices.
1
The author is an investment analyst with 30 years of experience. Currently part-time employed as a research
consultant to local broker and equity analysis instructor at 2 local universities in Thailand.
susheeln@gmail.com Forward Beta using Market and Stock Fundamentals December 2023
Results from a paper published Dr. Pablo Fernandezi that surveyed 2,500 professors show that
most of the professors who use Beta make use of regressions, webs, database, and textbooks.
Many of them also admit that these Betas are poorly measured and have many problems.
Another paper published by Jennifer Bender and Frank Nielsen from MSCI Research Insight ii
introduced some fundamental factors which are further split into qualitative and quantitative
factors. The former includes business model, competitive advantage, management quality and
corporate governance while the latter includes historical and estimates of capital structure,
revenues, earnings and cashflows. Another paper by B Rajesh Kumar and Manuel Fernandeziii
introduced risks elements associated with earnings and cashflows through variance of these
factors.
The major difference adopted by this paper is that the fundamental factors are defined from 2
perspectives namely, market-related fundamentals and stock-related fundamentals. Market-
related fundamentals are associated with the shape of the government yield curve, risk
appetite, including commodity prices or exchange rates in cases where markets are heavily
weighted towards businesses that are linked to commodity and exchange rates movements.
Stock-related factors include relative earnings growth (to the index), long-term earnings growth,
leverage, profitability, book value.
DISCUSSION
Beta can be described as a measure of a stock’s relative performance to that of a market index.
A stock with a Beta of 1 means it is expected to generate the same return as the index. A stock
with a Beta of more than 1 means it is expected to generate higher (or lower) returns than the
market index by the extent of its deviation from ‘1’.
Here we see that the interpretation of Beta is inherently subjective to the direction of the
market that one takes. A stock with a Beta of 1.5x means the stock is expected to generate
returns 1.5x higher than that of the index if the index goes up. Conversely, if the index goes
down, the stock can be expected to underperform the index by 1.5x.
The most common method of calculating Beta is to divide the covariance of returns between
the stock and index with the variance of the returns of the index. Mathematically, its formula
can be written as:
Beta of a Stock = Covariance of Stock Return and Index Return / Variance of Index Return
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Intuitively, the formula measures how strongly the two sets of returns are correlated to each
other. This correlation is then divided by the variability of the returns of the market to get a per
unit correlation to the variability of the index.
Beta can also be calculated using Excel spreadsheet through the use of the ‘Slope’ function and
Regression Analysis.
Some of the weaknesses in the use of traditional Beta are identified here.
1. Backward Looking
A major problem with the current definition is that Beta is derived only from past prices and the
past prices already reflected the prevailing market conditions and company outlook. This
methodology implicitly assumes that the economic environment, monetary conditions, relative
competitiveness against peers will remain the same in the future as in the past.
This point is better appreciated when we consider the entire process of valuation. When equity
analysts (buy-side or sell-side) estimate the value of equity, they start with developing financial
models to arrive at forecasts on Sales, Margins, Profits, Earnings Per Share (EPS), Cashflows etc.
This process is time-consuming and demands considerable efforts and experience to crystallize
their views about the industry, company operations and management strategy into a set of
assumptions that best fit their views of the future world.
Once the company’s bottom-up forecasts are made, analysts calculate the discount rate to
arrive at a fair value of equity. This discount rate may be either Weighted Average Cost of
Capital (WACC) or Required Returns on Equity (Rqd. ROE) depending on whether they want to
use free cashflows or EPS in the numerator.
Both WACC and Rqd. ROE further require the following variables as inputs:
- Long-Term Risk-Free Rate: This is often proxied as the 10-Year Government Bond Yield
(10Y GBY). Typically, the data can be read using current market yield which represents a
10-Year forward view of risk-free rate. In some cases, economists make their own
forecasts.
- Market Risk Premium (MRP): This risk premium is demanded by equity investors when
investing in the equity market (index). MRP is a measure of risk appetite and is often a
forward-looking number commonly estimated by market strategists.
- Cost of Debt: This can be calculated from the current bond yields or forecasts can be
made based on credit rating and credit spread. If the debts are not traded, the cost of
debt for the latest year can be adjusted to reflect changes in policy rates.
- Beta: In most cases known, historical prices are used to calculate Beta.
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All variables mentioned above reflect forward-looking views, except Beta. This considerably
undermines the worthiness of valuation.
2. Asymmetric Interpretations
The value of Beta used in framing investment portfolio depends on the direction of the market
that an investor takes. A Beta of more than 1 should be interpreted as positive to buy if one
takes a view that the market will be rising. But if one believes the market will fall, stocks with
Beta more than 1 should be avoided.
So higher or lower Beta must be interpreted within the context of market direction in order to
arrive at an actionable conclusion. This makes interpretations of Beta subjective to an assumed
outcome. Some have tried to apply ‘Up Beta’ or ‘Down Beta’. However, to apply them we still
need to have a view of future market direction in order to choose which Beta to use.
A potentially disruptive outcome is when market conditions during when Beta is calculated
become different than when it is applied.
3. Lookback Period
Choice of the lookback period can lead to differences in the calculation of Beta. A short
lookback period may reflect the most current conditions well but may not be appropriate to
apply in the long term. On the other hand, a long lookback period may ignore short-term
market cycles. In theory, the lookback period is supposed to cover a full industry cycle but
mapping the industrial cycle to price cycle itself is not a precise science.
Most academic papers prefer to use a relatively long lookback period. From the author’s
experience, a rolling daily 12-month or 6-month is commonly adopted by sell-side analysts. This
may appear short and periodicity too frequent but the arguments in their favor are:
1. Business cycles are becoming shorter. Product life cycles are getting shorter due to ease
in the adoption of new technology, already established distribution channels, efficient
logistics and increased competitiveness in every segment of the value chain. Shorter
industry cycles call for shorter lookback periods. Figure 2 reproduces a chart from a well-
known publication on valuation. It shows shorter product life cycles for newer products.
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Figure 1: Newer industries have shorter life cycles.
Source: Reproduced from the book: VALUATION MEASURING AND MANAGING THE VALUE OF COMPANIES, FIFTH EDITION, McKinsey &
Company. It further quotes the source from W. Cox and R. Alm, ‘You Are What You Spend”. New York Times, February 1, 2008.
2. A paper (New Data Shed Light on Mutual Fund Time Horizons | CLS Blue Sky Blog (columbia.edu) )
looking into the holding period of mutual funds based on Portfolio Trading Ratio (PRT)
showed that PTR increased from 26% in 1945 to 45% in 1975 and to 79% between 2005-
2015. A 100% PTR equals a holding period of 12 months; 79% theoretically puts the
average holding period at 15 months.
3. Decline in transaction costs, ease of trading, wider diversity and accessibility of equity
products and their derivatives all point to the down trending of vested period. According
to a paper published by the World Economic Forum (Long-term investing: what are the reasons
behind its decline? | World Economic Forum (weforum.org)), average holding of a stock in the New
York Stock Exchange (NYSE) has declined from 8 years in the late 1950s to 5.5 months as
of June 2020. Note that this is an average holding period for all types of investors
computed from total trades. It is likely that much of that dramatic decline has been led
by increased participation of retail investors and high-frequency traders.
4. Empirically, we see sell-side analysts’ coverage moving from making annual forecasts to
quarter forecasts, suggesting that milestones of investments are getting shorter.
Quarterly earnings conference calls for large companies have often become prime-time
content among mass media as well. Shortermism is in vogue – whether we like it or not.
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With compensation for executives tied to stock prices and stock options, this trend will
not be easily reversed.
4. No-Man’s Land
It is understandable that once economists and strategists have made estimates of 10Y GBY and
MRP respectively, their analytical tasks are considered delivered. It also appears that equity
analysts’ major analytical tasks are considered done once they have completed financial
forecasts as valuation is often seen as a mathematical process.
This leaves out Beta under-scrutinized as a parameter that finds the equilibrium point between
market conditions and company fundamentals. This point is explained in the next section. The
paper suggests that the role of equity analyst be expanded to cover Beta forecast too since Beta
is a factor associated with the valuation of a stock.
Note that the author recognizes that the roles of economists, strategists and analysts simply do
not stop once results of analysis are made. They also need to write papers, market their works,
and continually monitor their views.
METHODOLOGY
The method proposed in this paper eliminates some weaknesses discussed above. Let us begin
with the CAPM formula to calculate a discount rate.
Rqd. ROE = Long-Term Risk-Free Rate + MRP x Beta
Substituting Long-Term Risk-Free Rate with 10Y GBY:
Rqd. ROE = 10Y GBY + (MRP x Beta)
Rqd. ROE – 10Y GBY = MRP x Beta
Equity Risk Premium (ERP) = MRP x Beta
Beta = ERP / MRP
= Function of ERP and MRP
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Figure 2: Beta creates price discovery between market dynamics and company fundamentals.
Top-Down Macro Conditions: Bottom-Up Company
Economists estimate LT Risk Free Fundamentals:
and Strategists estimate MRP. Analysts take views on industry and
Together, we get Rqd. ROE for an company outlook. They make
equity index. financial forecasts.
Beta
Beta finds the
equilibrium point
between top-down
market dynamics and
company fundamentals.
From the formula above, the Rqd. ROE can be observed as it is the realized Earnings Yields (EY)
of a stock. EY is derived by dividing consensus earnings estimates with stock price. Subtracting
EY with 10Y GBY results in ERP of the stock. MRP can be similarly calculated by replacing
forward earnings consensus estimates of a stock with forward earnings consensus estimates of
the index and replacing the stock price with the index. With ERP and MRP known, realized Beta
can be calculated.
Viewing Beta as a function of ERP and MRP offers an intuitive insight into its drivers. Beta
becomes a number that reflects the results of interaction between fundamental factors of a
stock and fundamental factors of the market.
Next, we list these fundamental factors of a company and market (index) that can be
independently observed and forecasted which can have influence on ERP and MRP. We have
shortlisted the following.
Company Factors:
1. 12-Month Forward Relative EPS Growth (12M FWD Rel. EPS Growth). This refers to the
expected EPS growth of the stock over the next 12-month period less that of the
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expected EPS growth of the index over the next 12-month period. The more the
deviation of stock EPS growth over that of the index, the greater is the potential to
outperform or underperform the index.
2. 3-Year Forward EPS Growth (3Y FWD EPS Growth). This factor takes into account stocks
that are expected to have strong growth in the longer term even though the near-term
outlook does not look attractive. In cases where 3Y forward EPS are not available, 2Y
estimates are used.
3. 12-Month Forward Book Value (12M FWD BV). This is to take into account stocks that do
not have strong earnings growth or sectors where valuation is more driven from the
angle of value.
4. 12-Month Forward ROE (12M FWD ROE). Slow growth stocks tend to trade based on
their BVs and profitability on equity.
5. 12-Month Forward Net Debt Equity Ratio (12M FWD D/E). The degree of leverage can
have an influence on stock prices.
Market Factors:
1. 10Y GBY. The 10Y Government Bond Yield is widely used as a benchmark for long-term
risk-free rates. Its movement has a great impact on the valuation of financial assets.
2. 2Y GBY. The 2Y Government Bond Yield is included to take into account the near-term
interest rate direction.
3. In some markets where the constituents’ business is much driven by exports, we should
include the exchange rate as a factor as well. We have used Euro/USD (USDEUR) and
Thai Baht/USD (USDTHB) exchange rates as inputs for EU and Thailand markets.
4. In a market where the index is heavily weighted towards a commodity, we should also
include that commodity as a fundamental factor. The Thai stock market has about 20%
of its market capitalization exposed to Energy sector, so we have included West Texas
Crude oil (WTI) price as a factor as well.
Once these factors are identified, their historical data points are used as independent variables
in a multiple regression with realized Beta (calculated as ERP/MRP) as the dependent variable.
Daily data going back 4 years from Jan-2019 to Dec-2022 are used to back-test. The choice of
period selected is to ensure that:
1. the analysis covers the pre-Covid period, during Covid and post-Covid, so practically
covering a business cycle.
2. Results from the back-test are used to estimate fair prices in the forward-test for the
following 1 quarter period ending Mar-2023. This date has been chosen because it is the
last date that forward-looking data is available for analysis in this paper.
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3. Alternatively, back-testing up to June-2022 has been considered to allow a for longer
period of forward testing. However, this option has not been selected because the
period between Jul-2022 to Dec-2022 corresponded to the period where LT GBY across
most countries rose sharply, which the author expects high levels of rates will prevail in
the future.
Both historical prices and forward-looking estimates used are sourced from Bloomberg.
We will call Beta calculated from multiple regression as Fundamental Beta or Beta (f). This is to
differentiate from the traditional approach of using historical prices which we will call Beta (p).
Figure 3: Steps to calculation Fundamental Beta or Beta (f)
1. Calculate daily Realized ERP of a stock.
• (12M FWD EPS Estimate / Stock Price) – 10Y GBY
2. Calculate daily Realized MRP of an index.
• (12M FWD EPS Estimate of index / Index) – 10Y GBY
3. Calculate daily Realized Beta = ERP/MRP. This is the Realized Beta which will be used as a Dependent
Variable in a multiple regression.
4. The 9 identified financial variables above are used as independent variables. The variables should be
those that can be forecasted in order to enable forecast Beta to be calculated.
5. Run the multiple regression with the minimum threshold to accept at adjusted R2 of 75% and p-value
of individual variables at less than 5%.
6. Using coefficients from the multiple regression, Beta (f) can be calculated.
7. As forecasts of independent variables are available, forecast Beta can be calculated.
Figure 4 shows an excel cut-out of inputs from the multiple regression analysis. The example
shown is ‘Microsoft Corporation’. Note that independent variable ‘12M FWD ROE’ has been
ignored as its p-value did not pass the minimum 5% test.
Figure 4: Excel cut-out on regression analysis for ‘Microsoft Corp.’
Dependent Fundamental
Independent Variables
Variable Beta
12M FWD 3Y FWD
12M FWD Realized Beta
12M D/E Rel. EPS EPS 2Y UST Y 10Y UST Y Beta (f)
BV (ERP/MRP)
Growth Growth
2-Jan-19 -45.8% 10.5% 33.6% 13.7 2.47% 2.62% 0.49 0.50
3-Jan-19 -45.8% 10.6% 33.6% 13.7 2.38% 2.55% 0.52 0.50
4-Jan-19 -45.8% 10.9% 33.6% 13.7 2.49% 2.67% 0.49 0.49
7-Jan-19 -45.8% 11.3% 33.6% 13.8 2.54% 2.70% 0.49 0.49
8-Jan-19 -45.8% 11.5% 33.7% 13.8 2.59% 2.73% 0.49 0.49
22-Dec-22 -17.4% 9.7% 15.5% 34.0 4.27% 3.68% 0.29 0.22
23-Dec-22 -17.4% 9.7% 15.5% 34.0 4.32% 3.75% 0.27 0.21
26-Dec-22 -17.4% 9.8% 15.5% 34.1 4.32% 3.75% 0.27 0.21
27-Dec-22 -17.4% 9.8% 15.5% 34.1 4.37% 3.84% 0.25 0.20
28-Dec-22 -17.4% 9.9% 15.5% 34.1 4.35% 3.88% 0.25 0.20
29-Dec-22 -17.4% 10.0% 15.5% 34.2 4.36% 3.81% 0.23 0.20
30-Dec-22 -17.4% 9.9% 15.5% 34.2 4.43% 3.87% 0.22 0.20
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Figure 5 shows the results from multiple regression analysis with regressed adjusted R2 at 0.91.
Figure 6 shows the results of valuation of back-test from Jan-19 to Dec-22 and the forward-test
from Jan-23 to Mar-23. Note that macro factors in the forward test are assumed to remain the
same as the last day in Dec-22 but company factors during the forward test are based on
Bloomberg consensus estimates.
Figure 5: Regression results for ‘Microsoft Corp.’
Figure 6: Fair Price of ‘Microsoft Corp.’ Back-Test and Forward-Test
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A total of 15 stocks have been used to demonstrate the results from using the proposed
method. The 15 stocks chosen are based on geography, level of market development and their
market capitalization including USA (S&P500) Eurozone (STOXX index) and Thailand-Asia (SET
index). Thailand has been chosen because it is the home country of the author.
Chart 7: List of stocks included in the sample.
Stocks Company Name Short Name Industry Market Cap. (USD Bn)
Geography: US - S&P500 Index
1 Microsoft Corp. MSFT Technology 2,500
2 Alphabet Inc. GOOGL Technology 1,600
3 Amazon.com Inc. AMZN Consumer Discretionary 1,300
4 NVIDIA Corp. NVDA Technology 1,000
5 Meta Corp. META Technology 770
Geography: EU - STOXX Index
1 L'Oreal SA OR Consumer Goods 200
2 Vinci SA DG Construction & Services 80
3 Banco Santander SA SAN Financial Services 50
4 ASML Holding N.V. ASML Semi-Conductor 210
5 TotalEnergies SE TTE Oil & Gas Production 150
Geography: Thailand - SET Index
1 PTT Plc. PTT Oil & Gas Production 25
2 Kasikorn Bank KBANK Financial Services 10
3 CP ALL Plc. CPALL Commerce 14
4 Advanced Info Service Plc. ADVANC Technology 18
5 Siam Cement Plc. SCC Construction Materials 1
Results of regression analysis for the 15 stocks tested are summarized in Figure 8.
Figure 8: Results from regression analysis for stocks sampled.
12M FWD 3Y FWD USDEUR USDTHB
12M FWD 12M FWD 12M FWD Crude Oil
Code Adj. R2 Rel. EPS EPS 2Y GBY * 10Y GBY * Exchange Exchange
D/E BV ROE (WTI)
Growth Growth Rate Rate
USA
Microsoft Corp. MSFT 0.914161 x x x x - x x - - -
Alphabet Inc. GOOGL 0.656318 x x x x - x x x - -
Amazon.com Inc. AMZN 0.938832 x x x x x x x x - -
NVIDIA Corp. NVDA 0.748413 x x x x x x x x - -
Meta Corp. META 0.844856 x x x x x x x x - -
EU
L'Oreal SA OR 0.948488 x x x x x x x x
Air Liquid SA AI 0.923432 x x x x x x x x x -
Banco Santander SA SAN 0.793358 x x x x x x x x -
ASML Holding N.V. ASML 0.910791 x x x x x x x x x -
TotalEnergies SE TTE 0.901979 x x x x - x x x x -
Thailand
PTT Plc. PTT 0.918032 x x x x x x x - x x
Kasikorn Bank KBANK 0.807391 - x x x x x x - x -
CP ALL Plc. CPALL 0.953779 x x x x x x x - x x
Advanced Info Service Plc. ADVANC 0.801618 - x x x x x x x x
Siam Cement Plc. SCC 0.850787 x x x x x x x - x x
* US Treasury Yields for US, Germany Government Bond Yields for EU and Thailand Government Bond Yields for Thailand
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CONCLUSION
The provide validity to the approach proposed, it is necessary to compare the deviation of
observed stock price with the estimated fair values derived from using the 2 sets of Betas. The
following processes have been used.
- It is assumed that fair stock prices as of end Mar-23 need to be estimated. As data used
to back-test runs upto Dec-22, the process to estimate fair price at end Mar-23 needs to
occur at the end of Dec-22.
- Beta (f) is calculated using regression coefficients and company fundamental factors
estimated for period Mar-23. Beta (p) calculated as of end Dec-22 is used to apply to
forward period. Beta (p) is calculated based on a daily rolling 6-month basis.
- Data related to economy and market namely, 2Y GBY, 10Y GBY, Crude Oil price, Exchange
Rates and MRP is assumed to remain the same from Dec-22 through Mar-23. This
assumption will ensure that economic and market related data required as inputs to
calculate Rqd. ROE for the 2 sets of Beta is the same.
- The 12M FWD EPS estimates used are the same in both cases.
Results to the validation in Figure 9 show that deviation from fair price estimates using Beta (f)
are far lower than those of Beta (p) and with much less standard deviation (Figure 10).
Figure 9: Deviation predicted by Beta (f) is significantly lower than those of Beta (p)…
Predicted Fair Price for end Mar-23 Share Price Deviation: Share Price to Predicted
Stock Using Beta (f) Using Beta (p) as of Mar-23 Using Beta (f) Using Beta (p)
MSFT 262 157 284.1 9% 81%
GOOGLE 101 88 100.9 0% 15%
AMAZON 115 40 102.0 -11% 154%
NVDA 162 58 273.8 69% 371%
META 111 150 207.8 88% 38%
OR 357 155 405.6 14% 162%
AI 138 79 152.7 11% 94%
SAN 4 7 3.5 -7% -50%
ASML 554 N.A. 623.7 13% N.A.
TTE 48 165 54.4 13% -67%
PTT 34 57 31.3 -8% -45%
KBANK 139 340 133.5 -4% -61%
CPALL 73 34 62.3 -14% 84%
ADVANC 193 218 211.0 9% -3%
SCC 304 486 315.0 4% -35%
Average 12% 53%
Std. Deviation 28% 116%
* ASML’s share price predicted by Beta (p) gives a negative number. With 10Y GBY at 2.74%, Beta (p) at 1.79% and MRP at
6.00%, the Rqd. ROE gives a negative number.
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Figure 10: …with much less standard dispersion of errors.
400%
NVDA
350%
300%
250%
Deviation from Beta (p)
200%
AMAZON
OR
150%
AI
100%
CPALL MSFT
50% ADVANC META
PTT GOOGLE
0% ASML
-20% 0% 20% 40% 60% 80% 100%
SCC
-50%
TTE
SAN KBANK
-100%
Deviation from Beta (f)
Difference between Beta (p) and Beta (f)
Key differences between Beta-f and Beta-p can be summarized below.
Figure 11: Summary of features between Beta (f) and Beta (p)
Issue Beta (f) Beta (p)
Nature of data Forward-looking factors Historical share prices
Fundamental factors with choice
Scope of data depending on uniqueness of market Only price data is used
and company
Asymmetric outcome Eliminated Possible
Fundamental and economic factors Price pattern less easily defined as
Lookback period
easier to define as cycles cycles
Cannot be interpreted in the
traditional way. Beta (f) is simply the
Interpretation best-fit ratio between company Implications of higher (lower) than 1.
fundamentals with market and
economic factors.
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LIMITATIONS
The proposed Beta (f) has some weaknesses.
1. Forward consensus estimates of companies are needed. This will limit the scope of
analysis based on this approach to larger stocks that are well covered by sell-side
analysts. There should also be a minimum number of analysts covering a stock to ensure
the quality of estimates. A financial platform, which can be expensive, is also needed to
get access to such data.
2. It is possible that Beta (f) becomes a negative number in cases where a stock
consistently traded at very high valuation in the past due to expectation of high growth,
resulting in negative ERP (where historical EY was consistently lower than 10Y GBY). A
possible way out is to use Sales/Stock Price instead of EY. However, this option has not
been tested.
Susheel Narula
Susheeln@gmail.com
December 2023
REFERENCE
i
Dr. Pablo Fernandez, Betas Used by Professors: A Survey with 2,500 Answers, Working Paper
WP-822 published by IESE Business School, University of Navarra, published in September, 2009
ii
The Fundamentals of Fundamental Factor Models by Jennifer Bender and Frank Nielsen
published by MSCI Research, June 2010.
iii
Examination of Index Model and Prediction of Beta by B Rajesh Kumar and Manuel Fernandez
from Institute of Management Technology (Dubai, UAE) and Skyline University College (Sharjah,
UAE).
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