William F.

Sharpe
By CORY MITCHELL
 Updated May 14, 2019
Who is William F. Sharpe?
William Forsyth Sharpe is an American economist who won the 1990 Nobel Prize
in Economic Sciences, along with Harry Markowitz and Merton Miller, for
developing models to assist with investment decision making.

Sharpe is well known for developing the capital asset pricing model (CAPM) in

the 1960s. The CAPM describes the relationship between systematic risk and
expected returns, and states that taking on more risk is necessary to earn a
higher return. He is also known for creating the Sharpe ratio, a figure used to
measure the risk-to-reward ratio of an investment.

Life of William F. Sharpe

William Forsyth Sharpe was born in Boston on June 6, 1934. He and his family
eventually settled in California, and he graduated from Riverside Polytechnic
High School in 1951. After several false starts in deciding what to study at
college, including abandoned plans to pursue medicine and business
administration, Sharpe decided to study economics. He graduated from the
University of California at Berkley with a Bachelor of Arts degree in 1955 and a
Master of Arts degree in 1956. In 1961, he earned a Ph.D. in economics from the
University of California at Los Angeles.

Sharpe has taught at the University of Washington, the University of California at

Irvine, and Stanford University. He has also held several positions in his
professional career outside of academia. Notably, he was an economist at RAND
Corporation, consultant at Merrill Lynch and Wells Fargo, founder of Sharpe-
Russell Research in conjunction with Frank Russell Company, and founder of the
consulting firm William F. Sharpe Associates. Sharpe received many awards for
his contribution to the field of finance and business, including the American
Assembly of Collegiate Schools of Business award for outstanding contribution to
the field of business education in 1980, and the Financial Analysts Federated
Nicholas Molodovsky Award for outstanding contribution to the [finance]
profession in 1989. The Nobel Prize award he won in 1990 is the most
prestigious achievement.

KEY TAKEAWAYS

 William F. Sharpe is an economist credited with developing the CAPM and

Sharpe ratio.
  The CAPM is a cornerstone in portfolio management and seeks to find the
expected return by looking at the risk-free rate, beta, and the market risk
premium.
 The Sharpe ratio helps investors decipher which investments provide the
best returns for the risk level.
Contributions to Financial Economics
Sharpe is most well-known for his role in developing CAPM, which has become a
foundational concept in financial economics and portfolio management. This
theory has origins in his doctoral dissertation. Sharpe submitted a paper
summarizing the basis for CAPM to the Journal of Finance in 1962. Although it is
now a cornerstone theory in finance, it originally received negative feedback from
the publication. It was later published in 1964 following a change in editorship.

The CAPM model theorized that the expected return of a stock should be
the risk-free rate of return plus the beta of the investment multiplied by
the market risk premium. The risk-free rate of return compensates investors for
tying up their money, while the beta and market risk premium compensates the
investor for the additional risk they are taking on over and above simply investing
in treasuries which provide the risk-free rate.

Sharpe also created the oft-referenced Sharpe ratio. The Sharpe ratio measures
the excess return earned over the risk-free rate per unit of volatility. The ratio
helps investors determine if higher returns are due to smart investment decisions
or taking on too much risk. Two portfolios may have similar returns, but the
Sharpe ratio shows which one is taking more risk to attain that return. Higher
returns with lower risk is better, and the Sharpe ratio helps investors find that
mix.

In addition, Sharpe's 1998 paper, Determining a Fund's Effective Mix, is credited

as being the foundation of return-based analysis models, which analyze historical
investment returns in order to determine how to classify an investment.

Example of How Investors Use the Sharpe Ratio

Assume an investor wants to add a new stock to their portfolio. They are
currently considering two and want to pick the one with the better risk-adjusted
return. They will use the Sharpe ratio calculation.

Assume the risk-free rate is 3%.

Stock A has a returned 15% in the past year, with volatility of 10%. The Sharpe
ratio is 1.2. Calculated as (15-3)/10.
Stock B has returned 13% in the past year, with volatility of 7%. The Sharpe ratio
is 1.43. Calculated as (13-3)/7.

While stock B had a lower return than stock A, the volatility of stock B is also
lower. When factoring in the risk of the investments, stock B provides a better
mix of returns with lower risk. Even if stock B only returned 12%, it would still be
a better buy with a Sharpe ratio of 1.29.

The prudent investor chooses stock B, because the slightly higher return
associated with stock A doesn't adequately compensate for the higher risk.

CAPM Beta
Home » Valuation » Discounted Cash Flow » CAPM Beta

CAPM Beta is a theoretical measure of the way how a single stock moves
with respect to the market, by taking correlation between the both;
market represents the unsystematic risk and beta represents the
systematic risk.

CAPM Beta – When we invest in stock markets, how do we know that stock A
is less risky than stock B. Differences can arise due to market capitalization,
revenue size, sector, growth, management, etc. Can we find a single measure
that tells us which stock is riskier? The answer is YES and we call this as CAPM
Beta or Capital Asset Pricing Model Beta.

In this article, we look at the nuts and bolts of CAPM Beta –

 CAPM Beta 

 CAPM Beta Formula

 What is Beta?

 Key Determinants of Beta

 High Beta Stocks/Sectors

 Low Beta Stock/Sectors

 CAPM Beta Calculation in Excel

 Levered vs Unlevered Beta

 How to calculate the beta of unlisted or private firms

 Negative Beta? Examples

 Advantages of CAPM Beta

 Disadvantages of CAPM Beta

What is CAPM Beta?

Beta is a very important measure that is used as a key input for Discounted
Cash Flow or DCF valuations.

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Most Important – Download Beta Calculation Excel Template

Calculate the BETA of MakeMyTrip in Excel using SLOPE and Regression

CAPM Beta Formula

If you have a slightest of the hint regarding DCF, then you would have heard
about the Capital Asset Pricing Model (CAPM) that calculates the Cost of
Equity as per the below Beta formula.

Cost of Equity = Risk Free Rate + Beta x Risk Premium

If you have not heard of Beta yet, then worry not. this article explains to you
about Beta in the most basic way.

Let us take an example: when we invest in stocks, it is but human to pick

stocks that have the highest possible returns. However, if one chases only
returns, the other corresponding element is missed i.e. Risk.

Actually, every stock is exposed to two types of risks

 Non-Systematic Risks include risks that are specific to a company or

industry. This kind of risk can be eliminated through diversification

across sectors and companies. The effect of diversification is that

the diversifiable risks of various equities can offset each other.

 Systematic Risks are those risks that affect the overall stock markets.

Systematic risks can’t be mitigated through diversification but can be

well understood via an important risk measure called as “BETA”

What is Beta?

Basic Definition of Beta – Beta measures the stock risks in relation to the
overall market.
 If Beta = 1: If Beta of the stock is one, then it has the same level of risk

as the stock market. Hence, if the stock market (NASDAQ and NYSE etc)

rises up by 1%, the stock price will also move up by 1%. If the stock

market moves down by 1%, the stock price will also move down by 1%.

 If Beta > 1: If the Beta of the stock is greater than one, then it implies a

higher level of risk and volatility as compared to the stock market.

Though the direction of the stock price change will be the same,

however, the stock price movements will be rather extremes. For

example, assume the Beta of the ABC stock is two, then if the stock

market moves up by 1%, the stock price of ABC will move up by two

percent (higher returns in the rising market). However, if the stock

 market moves down by 1%, the stock price of ABC will move down by

two percent (thereby signifying higher downside and risk).

 If Beta >0 and Beta<1: If the Beta of the stock is less than one and

greater than zero, it implies the stock prices will move with the overall

market, however, the stock prices will remain less risky and volatile. For

example, if the beta of the stock XYZ is 0.5, it means if the overall market

moves up or down by 1%, XYZ stock price will show an increase or

decrease of only 0.5% (less volatile)

In general, large companies with more predictable Financial Statements and

profitability will have a lower beta value. For example, Energy, Utilities and
Banks, etc, all tend to have lower beta. Most betas normally fall between 0.1
and 2.0 though negative and higher numbers are possible.

Key Determinants of Beta

Now that we understood Beta as a measure of Risk, it is important for us to

also understand the sources of risks. Beta depends on a lot of factors – usually,
the nature of the business, operating and financial leverages, etc.

Below diagram shows the key determinants of Beta –

 Nature of Business – The beta value for a firm depends on the kind

of products and services offered and its relationship with the overall

macro-economic environment. Note that Cyclical companies have

higher betas than non-cyclical firms. Also, discretionary product firms

will have higher betas than firms that sell less discretionary products

 Operating leverage: The greater the proportion of fixed costs in the

cost structure of the business, the higher the beta

  Financial leverage: The more debt a firm takes on, the higher the beta

will be of the equity in that business. Debt creates a fixed cost, interest

expenses, that increases exposure to market risks

High Beta Stocks/Sectors

Due to the uncertain economic environment, questions always remain on what

is the best investment strategy. Should I pick high CAPM Beta stocks or Low
CAPM Beta Stocks? It is normally understood that cyclical stocks have high
Beta and defensive sectors have low Beta.

Cyclical stocks are those whose business performance and stock performance
is highly correlated with economic activities. If the economy is in recession,
then these stocks exhibit poor results and thereby stock performance takes a
beating. Likewise, if the economy is on a high growth trajectory, cyclical stocks
tend to be highly correlated and demonstrate a high growth rate in business
and stock performances.

Take for example, General Motors, its CAPM Beta is 1.43. This implies if the
stock market moves up by 5%, then General Motors stock will move up by 5 x
1.43 = 7.15%.

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The following sectors can be classified as cyclical sectors and tend to exhibit
High Stock Betas.

 Automobiles Sector

 Materials Sector

 Information Technology Sector

 Consumer Discretionary Sector

 Industrial Sector

 Banking Sector

Low Beta Stocks/Sectors

Low Beta is demonstrated by stocks in the defensive sector. Defensive
stocks are stocks whose business activities and stock prices are not correlated
with economic activities. Even if the economy is in recession, these stocks tend
to show stable revenues and stock prices.  For example PepsiCo, its stock beta
is 0.78. If the stock market moves down by 5%, then Pepsico stock will only
move down by 0.78×5 = 3.9%.

Following sectors can be classified as defensive sectors and tend to exhibit

Low Stock Betas-

 Consumer Staples

 Beverages

 HealthCare

 Telecom

 Utilities

CAPM Beta Calculation in Excel

Technically speaking, Beta is a measure of stock price variability in relation to

the overall stock market (NYSE, NASDAQ, etc). Beta is calculated by
regressing the percentage change in stock prices versus the percentage
change in the overall stock market. CAPM Beta calculation can be done very
easily on excel.
Let us calculate Beta of MakeMyTrip (MMTY) and Market Index as NASDAQ

Most Important – Download Beta Calculation Excel Template

Calculate the BETA of MakeMyTrip in Excel using SLOPE and Regression

Step 1 – Download the Stock Prices & Index Data

for Past 3 years 
The first step is to download the stock price and Index data. For NASDAQ,
download the dataset from Yahoo Finance
Likewise, download the corresponding stock price data for MakeMyTrip
example from here.

Step 2 – Sort the Dates & Adjusted Closing Prices

Once you have downloaded the data set for the two, please do the following
for each of the data set-
  Sort the dates and Adjusted Closing prices in ascending order

 Delete Open, High, Low, Close & Volume Column. They are not required

for Beta Calculations. 

Step 3 – Prepare a single sheet of Stock Prices Data

& Index Data
 

Step 4 – Calculate the Fractional Daily Return

Step 5 – Calculate Beta – Three Methods

You can use either of the three methods to calculate Beta – 1)
Variance/Covariance Method 2) SLOPE Function 3) Data Regression
  Variance / Covariance Method 

Using the variance-covariance method we get the Beta as 0.9859 (Beta

Coefficient)

 SLOPE function in excel 

Using this SLOPE function method, we again get the Beta as 0.9859 (Beta
Coefficient)

 3rd Method – Using Data Regression

For using this function in excel, you need to go to the Data Tab and select
Data Analysis.

If you are unable to locate Data Analysis in Excel, then you need to install the
Analysis ToolPak. This process is relatively easy: Go to FILE -> Options ->
Add-Ins -> Analysis ToolPak -> Go -> Check Analysis ToolPak -> OK
Select Data Analysis and click on Regression.

Choose the Y Input Range and X Input Range

Once you click OK, you get the following Summary Output
As noted above, you get the same answer of Beta (Beta Coefficient) in each
of the methods. 

Also, note that MakeMyTrip beta is approximately closer to 1.0, this implies

that MakeMyTrip stock prices have the same level of risk as to the broad
NASDAQ Index.

Levered vs Unlevered Beta

Levered Beta or Equity Beta is the Beta that contains the effect of capital
structure i.e. Debt and Equity both. The beta that we calculated above is the
Levered Beta.

Unlevered Beta is the Beta after removing the effects of the capital structure.
As seen above, once we remove the financial leverage effect, we will be able
to find the Unlevered Beta.
Unlevered Beta can be calculated using the following formula –

As an example, let us find out the Unlevered Beta for MakeMyTrip.

Debt to Equity Ratio (MakeMyTrip) = 0.27

Tax Rate = 30% (assumed)

Beta (levered) = 0.9859 (from above)

Calculate Beta of an Unlisted or

Private Company

As seen earlier, Beta is a statistical measure of the variability of a company’s

stock price in relation to the stock market overall. However, when we evaluate
private companies (not listed), then how should we find Beta? In this case,
Beta does not exist, however, we can find an IMPLIED BETA from
the comparable companies analysis.

Implied Beta is found using the following 3 step process –

Step 1 – Find all the Listed Comparables whose
Beta’s are readily available.
Please note that the Betas that you download are Levered Betas and hence, it
is important to remove the effect of capital structure. The higher amount of
debt implies higher variability in earnings (Financial Leverage) which in turn
results in higher sensitivity to the stock prices.

Let us assume here that we want to find the Beta of a private company, let’s
call this as PRIVATE. As a first step, we find all the listed peers and identify
their Betas (levered)

Step 2 – Unlever the Betas 

We will use the formula discussed above to Unlever the Beta.

Please note that for each of the competitors, you will have to find the
additional information like Debt to Equity and Tax Rates. While unlevering, we
will be able to remove the effect of financial leverage.
Step 3: Relever the Beta
We then relever the beta at an optimal capital structure of the PRIVATE
company as defined by industry parameters or management expectations. In
this case, ABC company is assumed to have the Debt/Equity of 0.25x and Tax
Rate of 30%.

The calculation for the relevered beta is as follows:

It is this relevered Beta that is used for calculating the Cost of Equity of the
Private companies.

What Does a Negative Beta Mean?

Though in the above cases we saw that Beta was greater than zero, however,
there may be stocks that have negative betas. Theoretically, the negative beta
would mean that the stock moves in the opposite direction of the overall stock
market. Though these stocks are rate, but they do exist. Many companies that
are into gold investing can have negative betas because gold and stock
markets move in the opposite direction. International companies may also
have negative beta as their business may not be directly linked to the
domestic economy.

If you are curious to see some examples of Negative Beta Stocks, here is the
process through which you can hunt for negative beta stocks.

Step 1 – Visit Yahoo Screener

Step 2 – Choose the Industry Filter
You may choose the sector/industry of your choice. I have picked up Gold
(Basic Materials)
Step 3 – Choose the Beta Values Minimum and
Maximum

Step 4 – Click on Find Stocks and you will see the list
below
Step 5 – Sort the Beta column from Low to High
Step 6 – Enjoy the list of Negative Betas 

Advantages of CAPM Beta

 Single measures to provide an understanding of security volatility as

compared to the market. This understanding of stock volatility helps the

 portfolio manager with his decisions of adding or deleting this security

from the portfolio.

 Most of the investors have diversified portfolios from which

unsystematic risk has been eliminated. Beta only considers systematic

risk thereby providing the real picture of the risks involved.

Disadvantages of CAPM Beta

 “Past Performance is no guarantee of future” – This rule also applies

on Beta. While we calculate beta, we take into account historical data – 1

year, 2 years or 5 years, etc. Using this historical beta may not hold true

in the future.

 Cannot accurately measure Beta for new Stocks – As we saw from

above that we can calculate beta of unlisted or private companies.

However, the problem lies in finding the true comparable that can

provide us with an implied Beta number. Unfortunately, we do not

always have the right comparable for start-ups or private companies.

  Beta does not tell us whether the stock was more volatile during the

bear phase or the bull phase. It does not distinguish between upswings

or downswing movements.

What is the Beta Coefficient?

The Beta coefficient is a measure of sensitivity or correlation of a security or investment
portfolio to movements in the overall market. We can derive a statistical measure of risk by
comparing the returns of an individual security/portfolio to the returns of the overall market and
identify the proportion of risk that can be attributed to the market.

 
 

Systematic vs Unsystematic Risk

We can think about unsystematic risk as “stock-specific” risk and systematic risk as “general-
market” risk. If we hold only one stock in a portfolio, the return of that stock may vary wildly
compared to the average gain or loss of the overall market as reflected by a major stock index
such as the S&P 500. However, as we continue adding more to the portfolio, the portfolio’s
returns will gradually start more closely resembling the overall market’s returns. As we diversify
our portfolio of stocks, the “stock-specific” unsystematic risk is reduced.
Systematic risk is the underlying risk that affects the entire market. Large changes in
macroeconomic variables, such as interest rates, inflation, GDP, or foreign exchange, are
changes that impact the broader market and that cannot be avoided through diversification. The
Beta coefficient relates “general-market” systematic risk to “stock-specific” unsystematic risk by
comparing the rate of change between “general-market” and “stock-specific” returns.

The Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (or CAPM) describes individual stock returns as a function of
the overall market’s returns.

Each of these variables can be thought of using the slope-intercept framework where Re = y, B =
slope, (Rm – Rf) = x, and Rf = y-intercept. Important insights to be gained from this framework
are:

1. An asset is expected to generate at least the risk-free rate of return.

2. If the Beta of an individual stock or portfolio equals 1, then the return of the
asset equals the average market return.
3. The Beta coefficient represents the slope of the line of best fit for each Re –
Rf (y) and Rm – Rf (x) excess return pair.

In the graph above, we plotted excess stock returns over excess market returns to find the line of
best fit. However, we observe that this stock has a positive intercept value after accounting for
the risk-free rate. This value represents Alpha, or, the additional return expected from the stock
when the market return is zero.
 

How to Calculate the Beta Coefficient

To calculate the Beta of a stock or portfolio, divide the covariance of the excess asset returns and
excess market returns by the variance of the excess market returns over the risk-free rate of
return:

Advantages of using Beta Coefficient

One of the most popular uses of Beta is to estimate the cost of equity (Re) in valuation models.
The CAPM estimates an asset’s Beta based on a single factor, which is the systematic risk of the
market. The cost of equity derived by the CAPM reflects a reality in which most investors have
diversified portfolios from which unsystematic risk has been successfully diversified away.

In general, the CAPM and Beta provide an easy-to-use calculation method that standardizes a
risk measure across many companies with varied capital structures and fundamentals.

Disadvantages of Using Beta Coefficient

The largest drawback of using Beta is that it relies solely on past returns and does not account for
new information that may impact returns in the future. Furthermore, as more return data is
gathered over time, the measure of Beta changes, and subsequently, so does the cost of equity.

While systematic risk inherent to the market has a meaningful impact in explaining asset returns,
it ignores the unsystematic risk factors that are specific to the firm. Eugene Fama and Kenneth
French added a size factor and value factor to the CAPM, using firm-specific fundamentals to
better describe stock returns. This risk measure is known as the Fama French 3 Factor Model.

Valuations and analysis of portfolio investments is critical work for many financial analysts. To
learn more about valuation methods and analysis, the following resources may be helpful.

Other Resources

 Valuation Methods
 Unlevered Beta
 Weighted Average Cost of Capital
 Investing: A Beginner’s Guide

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