(104)---DETERMINANTS OF BETA

Determinants of Beta

We have explained that beta is the ratio of covariance between returns on market and a security to variance of the market returns.

But what drives the variance and covariance? The variance and covariance and therefore, beta depend on three fundamental factors: the nature of business, the operating leverage and the financial leverage.
Those factors are discussed below.

Nature of Business

All economics go through business cycles. Firms behave differently with business cycles. The earnings of some companies fluctuate more with the business cycles. Their earnings grow during the growth phase of the business cycle and decline during the contraction phase.

For example, the earnings of consumer product firms or the cargo firms are tied with the business cycle and they go up or down with business cycle. On the other hand, the earnings of utility companies remind unaffected by the business cycle. If we regression a company’s earnings with the aggregate earnings of all companies in the economy, we would obtain a sensitivity index, which we can call the companies accounting beta. The real or the market beta is based on share market returns rather than earnings. The accounting betas are significantly correlated with the market betas.

This implies that if a firms earnings are more sensitive to business conditions, it is likely to have higher beta.

We must distinguish between the earnings variability and the earnings cyclically. A company’s earnings may be highly variable, but it may not have high beta. The earnings variability is an example of a specific risk that can be diversified. Cyclically of a companies earnings on the other hand, is the variability of its earnings Vi's-à-Vi's the aggregate earnings of the economy.