Beta analysis for Software Industry

Jun 08

Previously I calculated the beta (ß) and r-squared (R2) for Google and Microsoft relative to the market (DJIA). There are cases where it’s more useful to know how a company does relative to its peers or as part of a portfolio. Using the monthly values from that previous work, I compiled and ‘industry’ or ‘portfolio’ average of returns. That provided me with a ß and R2 for the industry.

As shown above, the software industry (my sample of GOOG and MSFT) has a ß=0.9847 and an R2=0.5163 relative to the market (DJIA). While that’s interesting, it’s also worth observing the ß and R2 of each company relative to the industry.

This table summarizes the observations in the plots shown above

Company Beta-market Beta-industry R2-market R2-industry
MSFT 1.0168 0.8919 0.4891 0.7066
GOOG 0.9526 1.1081 0.3101 0.7881

Some observations are less useful due to the small sample of only two companies. For example,  the ß values are proportionally distant from the industry. This is because the industry is made up of a sample of those two companies only. The R2 for the industry are very similar and both show better fit to data than the industry comparison.

CAPM

Recall that the cost of equity, re, can be obtained using the Capital Asset Pricing Model as follows:

$r_e = r_f + \beta(r_m-r_f)$

Using this and the data above, we can calculate the average cost of equity for the industry as represented by Google and Microsoft. We’ll use rf=0.1 and rm=6.2. That gives us:

$r_e = 0.1 + 0.9847(6.2-0.1)$

$r_e = 6.1067\%$

With the current economic state, the risk free rate has little impact on the equity rate. The beta for the industry relative to the market is also very tight, which reduces risk with respect to the market.

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