Some Betas Are Less Dead Than Others: Beta as a Predictor of Future Price Changes for Individual Stocks

Abstract

Why is beta a more effective price forecasting tool for some securities than others? Empirical studies of the basic capital asset pricing model (CAPM) are predominantly focused on the relationship between a portfolio’s returns and its beta. The model predicts a positive correlation. These studies employ portfolios to reduce the impact of firm-specific unsystematic risk on the analysis. By contrast, in this article, the authors examine beta as a forecasting tool for individual security values. The objective is not to validate the CAPM but instead to provide insight into how and why beta-driven forecasts of future value are more accurate for some firms than for others. They develop estimation models to explain 1) how well the market model fits the data (measured by R²s) and 2) forecast errors derived from the difference between actual and beta-predicted equity prices. They find market and company-related factors that explain differences in R² and forecast error within their sample. <b>TOPICS:</b>Portfolio theory, security analysis and valuation