Company share prices are subject to constant fluctuations on the financial markets. A decisive factor for the volatility of a share is the so-called beta factor. It indicates how strongly a company share reacts to general market developments. Understanding the beta factors is essential for an accurate business valuation. This is because it provides valuable information on the risk of an investment. In this article, we shed light on the relationship between the beta factors and the liquidity of a share. We explain how the two factors influence each other and what practical implications this has in practice.
The beta factor is a key performance indicator in the financial world. It measures the systematic risk of an investment compared to the market as a whole. Put simply, the beta factor shows how strongly the price of a share reacts to general market fluctuations.
A linear regression is usually used to calculate the beta factors. This involves plotting the historical returns of a share against the returns of a corresponding market index (DAX, S&P 500). The slope of the resulting regression line corresponds to the beta factors.
Daily, weekly and monthly returns can be used as the basis for the calculation. The choice of time period depends on how in-depth the analysis is to be and what historical data is available.
The beta factors are a very value-sensitive variable. Even small changes in the underlying data can lead to significant deviations in the calculated company value.
In practice, investors use the beta factors to assess the risk of an investment. A high beta factor signals high volatility - and therefore a higher risk.
The beta factors are also an important component of the Capital Asset Pricing Model (CAPM), which is used to calculate the cost of capital for companies. The cost of capital is in turn decisive for business valuation.
The quality of the calculated beta factors depends largely on the liquidity of the underlying equity market: the more liquid a market is, the more reliable the beta factor tends to be.
However, so-called "noise" must be taken into account for the stock index under consideration. This is interference or noise in the data for daily, weekly or monthly returns, which overlays the actual underlying trends.
Noise occurs when markets are less liquid: due to a lack of trading days, a high bid-ask spread or low trading volumes caused by low demand. This leads to fundamentally unjustified jumps in prices and returns.
If returns that are distorted by noise are used in the calculation, the linear regression can lead to incorrect results. The calculated beta factors are then no longer representative of the actual systematic risk of the share. This results in incorrect business valuations.
Various key figures are available to assess the liquidity of a share. These provide information on how easy it is to buy or sell a share. The most important liquidity measures include
A high bid-ask spread, a low trading volume or a low number of trading days increase the "noise level" in the returns. This can distort the estimate of the beta factors. On the other hand, a high free float usually improves the data quality - and leads to a more reliable beta estimate.
Practical business valuation shows that the bid-ask spread and the trading volume in particular play a decisive role in assessing liquidity - and are therefore decisive for the reliability of the beta factors:
Case law also emphasizes the importance of liquidity for business valuation.
Numerous court rulings have emphasized that particular caution is required when valuing illiquid assets. It has also been established that the results of the valuation can be subject to corresponding uncertainties.
Examples include the judgments of the Higher Regional Court of Frankfurt am Main (decision of 26.1.2017 - 21 W 75/15) and the Regional Court of Stuttgart (NZG 2013, 342). Here it becomes clear that the liquidity of a share has a significant influence on the reliability of the business valuation.
Liquidity plays a decisive role, particularly when calculating the beta factors as a measure of the systematic risk of an investment.
Conclusion - the beta factor in the context of liquid equity trading
The beta factor, a central indicator of the systematic risk of an investment, is closely linked to the liquidity of the underlying equity market. In principle, the more liquid a market is, the more reliably the beta factor can be calculated.
Liquidity influences the quality of the data used to calculate the beta factors.
A high bid-ask spread, low trading volumes or few trading days lead to so-called "noise" in the data, which overlays the actual trends. This noise can lead to a distortion of the beta factors and thus to incorrect business valuations.
Conversely, high liquidity improves data quality. A high free float, narrow spreads and large trading volumes enable a more precise estimate of the beta factors.
The importance of liquidity for business valuation can also be seen in current case law. Courts have repeatedly emphasized that particular caution is required in the case of illiquid assets and that the results of the valuation may be subject to corresponding uncertainties.
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