Explanatory Power of Implied and Historical Betas in Comparison

Abstract

According to Markowitz Portfolio Theory, the systematic risk of an investment cannot be eliminated from a portfolio through diversification. The systematic risk is determined according to Sharpe, Lintner and Mossin, by the beta value. From a formal point of view, the beta value is determined by the covariance term, which describes the direction and strength of the correlation between the return of the security and market return, and its weighting with the variance return. Beta values are fundamentally determined using the historical returns of the security and the market portfolio which can lead to incorrect valuations. Use of implied beta values presents an alternative solutions. In this working paper we consider the determination of implied beta values, with the focus lying on the question as to whether implied beta values can explain stock prices better than historical beta values. In doing so, the respective implied costs of capital rtcapm of the companies concerned are first determined on the basis of analysts’ estimates using the three-stage RIM according to Hebhardt, Lee, Swaminathan (2001) as fundamental stock valuation model.