Why do different firms in same industry have very different betas?
The beta of a stock describes how the returns of the stock are correlated to the returns of the financial market as a whole. The value representing the returns of the financial market is that of the returns offered by a benchmark index. For example, in the US, the benchmark indexes that are used to determine the beta of stocks are the DJIA, the NASDAQ or the S&P 500 among many others.
All firms that are in the same industry do not have the same beta as the financial fundamentals of each firm is different. This could include the assets of the firm, the debt it has, the profits it is currently making and is expected to make in the future, the current price of the stock, the liquidity of the stock, etc.
In most instances when the beta of two firms in the same industry are being compared it is seen that firms that are more leveraged and have a lower price have a higher beta. The beta of firms that are generally not included in long term investor portfolios but instead are traded by short term speculators or traders have a higher beta. The beta of firms where the price of the stocks is very low and which are traded in large volumes, commonly known as penny stocks have a large beta compared to other more stable firms in the same industry.
There can be many reasons why the beta of firms in the same industry are not the same and it is quite difficult to provide an exact reason as they usually vary for different industries and between different firms.
The beta of a stock represents the volatility or market risk of investing in that stock. A stock with a beta greater than one is more volatile than the market in which it is listed. If its beta is less than one, then it is less volatile than the market in which it is listed. There are reasons why different firms in the same industry may have different betas.
One factor is how far back one goes in calculating the beta. A calculation going back three years will likely be different than a calculation going back five years. If different firms in the same industry use a different number of years to calculate the beta, the beta will likely be different.
Another factor that is involved would be the capital structure of each firm. Firms that have different capital structures will have different betas. For example, a company with less debt financing will have a lower beta than a company with higher debt financing.
The risk a company faces also impacts its beta. Companies in the same industry may face different risks, because they may have different operational strategies. For example, a company that extends credit to people with a poor credit history will face more risk than a company that doesn’t follow this practice. Companies with more risk will have a higher beta than companies with less risk.
Generally, firms within the same industry should have the same measure of risk (beta). However, external and internal factors at the firm and industry level may affect them differently, causing different betas.
Microeconomic factors may cause shifts in a firm’s beta, which results in differences between the firm and other firms in the industry. Some of the factors that may bring about such differences include situations where the firm changes its technology, products, or other major operational processes. Changing some of these fundamental aspects of the firm requires investment, and before recovery is achieved, the level of risk in such a firm may be slightly or considerably heightened compared to its peers in the same industry.
Macroeconomic factors, including factors such as the rate of inflation, have shown no considerable impact on firm betas given that such effects are standardized throughout the industry. However, individual firm strategies in addressing macroeconomic factors may cause instability in individual firm betas.
Thus, differences in firms’ betas within an industry can be explained by external and internal factors that have a bearing on how the firms operate in general.